ISOs hold unpleasant surprise in form of tax 
Published 11/20/01

If you exercised an Employee Incentive Stock Option ("ISO") during 2001 and the price of the stock has declined significantly, you may be in for an unpleasant surprise next April 15 th . The "surprise" is the Alternative Minimum Tax.

The Alternative Minimum Tax is an alternate (hence the name) tax system which attempts to prevent taxpayers from using too many preferences (benefits) by imposing a "minimum" tax on these preferences. One of these preferences is the favored tax treatment of ISOs.

When an ISO is exercised, the difference between the fair market value of the stock and the amount paid under the ISO plan is taxed as income under the Alternative Minimum Tax, which, depending upon your other items of income and deduction, may be 28% of that difference.

If the value of the stock has gone down significantly since the exercise of the option, you may be paying Alternative Minimum Tax on a non-existent gain.

In future years the Alternative Minimum Tax paid may be credited or refunded to you. However, in the area of ISOs, if you sell the stock for less than the fair market value of the option at exercise, the loss available for Alternative Minimum Tax purposes may be limited to $3,000 per year. So, unless you have other gains to offset the loss, it may take quite a while before you get credit for the Alternative Minimum Tax you paid in 2001.

So, what do you do now? There is a simple solution which should eliminate the problem. If you sell the stock this year you will either recognize ordinary gain or capital loss on the difference between the sale price and the amount you paid for the stock. There will be no preference item reported for Alternative Minimum Tax purposes, and hence, no Alternative Minimum Tax problem.

For example, if you paid $10,000 for an ISO valued at $20,000 and the price has dropped to $5,000, you will have $10,000 of Alternative Minimum Taxable Income for 2001 and may pay $2,800 of additional tax.

If you sell the stock in 2002, you will have a $5,000 loss ($10,000 cost less $5,000 sale price). For AMT purposes you will have a loss of $15,000 ($10,000 cost + $10,000 preference less $5,000 sale price), however, the loss may be limited to $3,000 each year for five years. If instead, you sold the stock in 2001, you will still have a $5,000 loss with no AMT implications.

If you find yourself in this position you should seek professional tax advice soon. For ISOs exercised in 2001 this planning idea expires on the last trade date in December 2001.

One note of caution, if you sell the stock at a loss and you plan to repurchase the same stock, you must wait at least 30 days before the repurchase, otherwise your loss will not be allowed under the "30-day wash sale" rule.

Joseph W. Kenny is a shareholder and director of Hamblett & Kerrigan, P.A., who concentrates his legal practice in the areas of estate planning and taxation. He is also a certified public accountant/personal financial specialist. You can reach Attorney Kenny by email at: jkenny@hamker.com

This information is general information and may not reflect the most current legal developments, verdicts or settlements. The information provided should not be relied upon as an indication of the actual state of the law or of future developments. The information contained on the Hamblett & Kerrigan website is for informational purposes only and does not constitute legal advice. If the information referenced may be of legal importance to you, you should consult with an attorney to provide you with legal guidance and opinion as the the effect of the current law upon your situation.