The beauty of incentive stock options is that you owe no income tax until you actually sell the stock. So why is freshly minted millionaire “Mike Smith” so irate about his tax bill?
It’s because although he doesn’t owe regular income tax on his options yet, he must scrape up about $2.5 million of Alternative Minimum Tax by April 15 if he hangs onto his stock into 2001. Worse, he’s on the hook for the full bill even though it is based on paper profits that have eroded — and could even vanish — in the free-falling stock market.
Smith was taking a tax-saving gamble that has paid off for many optionaires during an unprecedented bull run on Wall Street: By exercising their options and hanging onto their stock for more than a year, rather than selling for immediate profit, workers can qualify for a capital-gains break that can slash their tax bills.
But that strategy unravels when stock prices plummet. And now countless optionaires like Smith face an agonizing financial dilemma. They could wind up owing more in taxes than their stock is currently worth unless they abandon their initial strategy and dump some or all of their stock by year’s end.
The predicament is widespread enough to merit an “all-points bulletin on tax risk” in high-tech hamlets from Silicon Valley to Austin to the Research Triangle, warns Robert R. Pastore, a San Francisco certified public accountant and author of “Stock Options.” “Plenty of stocks have collapsed.”
No taxes are withheld on incentive stock options, and Smith’s $125,000 salary as a marketing director leaves him little means to pay that tax bill, other than to sell the stock at prices he’s convinced are depressed. With each sale, he sees hundreds of thousands of dollars of potential wealth vanish.
“It was neither my intention nor desire to sell stock until down the road. Now I’ve been forced to,” said Smith, who asked that his real name and company not be published to protect his privacy. “If the stock tanks, the IRS doesn’t care. They will want their $2.5 million.”
Financial experts say the problem could affect an unprecedented number of Silicon Valley workers because three powerful forces have intersected this year:
– More companies are giving more stock options to more people.
– With stock prices blowing through the roof in the spring, many optionaires figured the good times would continue, only to watch the tech-heavy Nasdaq stock market plunge as much as 50 percent since peaking in March.
– The Alternative Minimum Tax, which looms whenever you exercise incentive options and hold the stock into the next calendar year, is snagging middle-class taxpayers in alarming numbers, yet many optionaires are blind to the complexities of tangling with this often-misunderstood tax on the “rich.” Most taxpayers are shielded from the AMT by an exemption of $45,000 for couples and $33,750 for singles. But because the exemption has never been indexed for inflation, the AMT will snare about 1 million taxpayers this year, according to a new study by the bipartisan Congressional Joint Committee on Taxation.
“Rising expectations have created a sense of vulnerable optimism,” said Palo Alto, Calif., financial planner Curt Weil, who reports seeing an unusual stream of options-toting prospects at his door and hearing “horror stories” at professional meetings. “The psychology goes something like this: `I’ll exercise my options, and the stock will go up. In fact, it will go up so much that the increased profit will pay my taxes.’
“Only this time it didn’t.”
That scenario obviously applies to workers exercising incentive stock options at a host of onetime market darlings that have plunged along with the Nasdaq.
But it also should serve as a warning to optionaires who intend to exercise options and hold stock in some high-flying companies whose stocks could tumble, said Gabriel Fenton, a PaineWebber vice president and co-author of “Employee Stock Options.”
That potential plunge, together with the Alternative Minimum Tax, provides vivid evidence that squeezing the most from your incentive stock options is anything but simple and risk-free.
For perhaps the majority of people, it buttresses the logic of simultaneously exercising options and selling the stock, an act that forgoes tax savings in favor of locking up immediate wealth and investment security. Others, however, will take it as evidence that the real value of an option is in letting it ride — allowing optionaires to profit on paper without risking any cash or owing any taxes until they’re certain the stock has peaked or they need money.
For incentive stock optionaires, the insult of AMT is the promise of a credit that can be reclaimed in future years. In theory, the AMT is simply a prepayment, not an additional tax. The reality, however, is that the rules allow some taxpayers to nibble off only $3,000 of their AMT credit each year. Some never fully recoup their money. In short, the AMT is a twisted, tangled system that many critics are targeting for reform. In the meantime, however, financial advisers see the AMT as something to manage, not flee from in panic. Indeed, it’s sometimes advantageous, because the top AMT tax rate is 28 percent, well below the top 39.6 percent regular income tax bracket.
If you sell the stock in less than a year, the spread between your exercise and sale prices will be treated as income, at rates as high as 39.6 percent. But if you hold it longer, any profit above your exercise price qualifies for a long-term capital gain rate of no more than 20 percent.
The problem is you must contend with the Alternative Minimum Tax if you hold the stock from one year into another. That means that come April 15, you could owe AMT that’s based on the paper profit on the day you exercised your option.
Even if your stock later implodes.
The only way out is to surrender and sell the stock by year’s end. Such a sale creates what’s known as a “disqualifying disposition” that exposes you to regular income tax. But at least it’s based only on the spread between your strike price and your now depressed sale price. And at least you — not Uncle Sam — control your cash.
“You can solve this problem so easily by getting out this year,” said Pastore, the CPA and author.
Because of the double threat of the AMT tangle and a volatile stock market, many financial advisers say December is the worst time to exercise an incentive stock option. It gives you little time to re-evaluate a crumbling stock and decide whether to sell by year’s end. It also means the AMT bill comes due within four short months. If your only hope to pay the tax is to sell some of your stock before April 15, that leaves little time for the price to rebound.
By that definition, then, the best time to exercise incentive stock options is early in January. That gives you nearly a full year to monitor the stock and re-evaluate your strategy. It also gives you up to 16 1/2 months to round up the tax bill. When the stock market is running with the bulls, that cash-flow problem often takes care of itself. Not only do you slash your tax rate, but appreciation on your stock also takes a bite out of the AMT.
Alas, that strategy is misfiring this year. And many incentive stock optionaires can only circle Friday, Dec. 29 in red — the year’s last trading day — and wait with a sense of anxiety, if not dread.
