To attract and retain young, high-tech talent, many savvy employers offered Incentive Stock Options. Employees watched as stock prices reached feverish heights, only to plummet unmercifully later.
As if that weren’t bad enough, employees who exercised those options while the market was hot now must pay taxes on profits they may never see, thanks to the Alternative Minimum Tax.
“It’s been in the law for a number of years, and the theory behind was, at a minimum, all taxpayers should pay a certain level of tax,” says Robert Burak, partner in charge of tax services at Grant Thornton LLP in Cleveland. “The AMT system is designed at scaling back the incentives in the tax code today. That’s essentially what they’re aimed at doing.”
For example, let’s say the fair market value of the stock when the Incentive Stock Option was gifted was $10 per share. You exercise your option, get the stock, and it’s worth $20 per share, even though you only paid $10.
For regular income tax purposes, you don’t have to declare that additional $10 until you sell the stock. However, if you apply the AMT, it recognizes the extra $10 as income and the government gets its cut.
“Basically what AMT income is, is the difference between the fair market value when that option was granted and what it was when you exercised it,” says Edward Decker, a senior associate at SS&G Financial Services in Akron. “It’s something so small you don’t know it until it happens to you.”
In theory, the AMT was created as a prepayment on income a stockholder would earn when he or she sold the stock. The stockholder can earn credit down the line on taxes paid now, but due to the convoluted nature of the law, few taxpayers can claim much more than $3,000 a year in AMT credit.
It’s not just the dot-com millionaires who are getting hit by the AMT this tax season. Taxpayers who itemize and deduct state and local taxes from their federal income tax return could find themselves triggering the AMT — especially if state and local taxes are high in their area, Decker says.
“We see it a lot, and it’s not necessarily the high-income taxpayers,” he says. “State and local taxes are not allowed as an itemized deduction for AMT purposes. That’s the biggest adjustment we normally see. Maybe going forward, we’re going to see more of the Incentive Stock Options going on.”
What can you do? Obviously, consult a tax adviser, although it is a little late to do anything about it this tax season. Those who have exercised their Incentive Stock Options should definitely seek help before an unexpectedly large tax bill lands in their mailbox.
Selling the stock before year-end is usually an option, but some Incentive Stock Option plans prevent the employee from selling shares in the same year the option is exercised.
“Everybody’s facts and circumstances are much different,” Burak says. “It all depends on the number of shares being issued, the fair market value of the stock, the level of other income the individual makes.
“But the key point is, don’t wait until year-end to do it.” How to reach: Grant Thornton LLP, (216) 771-1400; SS&G Financial Services Co., (330) 668-9696
Morgan Lewis Jr. ([email protected]) is a reporter at SBN Magazine.
