Exercising Your Incentive Stock Options – Part III August 3, 2001February 20, 2017 If you don’t have stock options at work, do yourself a HUGE favor and skip this column. Seriously. Sreenivas I. Rao: ‘Lot of people have lost their houses paying the Alternative Minimum Tax (AMT) on ‘phantom gains’ here in the Silicon Valley. Check reformAMT.org. Some of the strategies discussed can backfire, with disastrous consequences.’ ☞ For a specific human face on one of these horror stories, click here. Marcus Wu: ‘Individuals selling ISOs should also beware of the 30-day wash sale rule under the Internal Revenue Code. Here’s an example of how those rules could zap you: Xavier exercises an incentive stock option in March when the stock is trading at $100/share. By December, it’s down 99% to $1/share. Xavier doesn’t want to pay AMT on stock valued at $100/share. He knows that if he sells the stock before the year is up, then the option is not treated as an ISO and there is no AMT due. WHEW! Xavier is relieved and sells. But he believes in the company and wants to ride the stock back up. So he buys some stock and makes the horrible mistake of doing so within 30 days of selling his ISO shares. Oh, no! Xavier owes the AMT — see 422(c)(2)(B) of the Code — because his December sale is negated (for tax purposes) as a ‘wash sale.’ ☞ Oh, no, indeed. The estimable Less Antman: ‘I have one quibble with a comment from one of your readers: As for paper millionaires stuck with AMT, they could always sell off some of their junk to generate some AMT loss (and get some cash to pay AMT on the rest of the gain). The AMT basis is the fair market price at exercise (the value used to compute the AMT gain). ‘Perhaps the reader meant selling the shares within the same calendar year (as another reader recommended when proposing that exercising should be done in January to allow time to decide), but this won’t help the Silicon Valley paupers stuck with the tax bills of millionaires: ‘(1) The net capital loss deduction for AMT purposes is limited to $3,000 per year, just as it is for regular purposes. If you exercised ISOs when there was a $1,000,000 spread, then sold the next year after a collapse caused it to totally disappear (or worse), you’d eventually get to claim the loss of $1,000,000 for AMT purposes, but might have to spread it out over the next 334 years. So unless there are lots of other capital gains lying around waiting to be had, this isn’t going to work. ‘(2) Any credit in a later year for AMT paid in an earlier year can only reduce the regular tax bill. After the high technology party ended, most of these people were left with only their regular salary (assuming their company wasn’t actually dot-gone), and the regular tax bill on the 2001 salary is going to be a pittance compared to the AMT paid in 2000. Even if they had later capital gains, the AMT rate is 28% on ISO exercises, so it is going to take a lot more long-term capital gains at 20% to get the tax benefit from all the ISO losses. Most of these people will NEVER recover the AMT paid, or anything remotely close. ‘The reader was correct in saying the ideal approach is to figure out how many ISOs can be exercised without triggering the AMT in the first place. And that it is a complicated calculation, which really means people with profitable options ought to pay for the services of a tax professional. But most of the Silicon Valley crowd thought they could do their own taxes with TurboTax, so they only found out when they sat down in April 2001 what they had done to themselves by exercising in early 2000 and holding for a year and a day. And then it was too late. ‘Which gets back to the point that the safest thing to do with any employee stock option, non-qualified or incentive, is hold until you have a good gain and then sell the shares immediately after exercise. Forget the taxes: it is almost inconceivable that the beneficiary of a giant stock option windfall isn’t, after exercise, going to have the majority of his net worth in a single stock, in the company which also pays his salary, and which is likely to be an overpriced stock given the price rise needed to create the windfall. The need for prudent diversification overrides the potential benefit of saving the spread between the ordinary and long-term capital gains rates by holding for over a year. The stock market as a whole can’t go to zero, but plenty of individual stocks drop below the exercise price of employee options, and some of them stay there permanently. ‘P.S. Kaye Thomas’ brilliant book, Consider Your Options, discusses this topic in excruciating detail.’