President Bush wants us to focus on taxes, taxes, taxes. OK, let’s do so.
Oddly enough, a serious gap in Bush’s tax-cut proposal was exposed by the collapse in the Nasdaq stock market last year.
In proposing to cut marginal tax rates and reduce the number of tax brackets to four from five, Bush forgot to address the alternative minimum tax, known fondly among tax experts as the AMT.
The AMT is a parallel tax universe that ensnared many high-tech whiz kids and could grab a much broader group of taxpayers if Bush’s tax plan is approved.
“It was enacted in the early 1980s to prevent high-income taxpayers utilizing certain deductions and tax provisions from effectively paying no income tax,” said Michael Simmons, a Chicago-based personal financial counselor for Ernst & Young.
Many executives of high-tech start-ups, especially California-based companies, were shocked to find themselves exposed to the AMT after they exercised options on their company’s stock early last year, just before the tech bubble burst.
Apparently, quite a few of them decided that the easy way out was to sell their company’s shares by the end of the year, deepening the Nasdaq’s slide.
The Nasdaq composite index, home to most of the high-tech high-fliers, plunged 900 points, or nearly 27 percent, in November and December, the biggest November-December drop ever by a major stock index, said James Bianco of Bianco Research in Barrington.
“Something caused the Nasdaq to make a vertical drop,” he said. “Somebody was forced to sell.”
In brief, taxpayers who may be subject to the AMT must restore to their taxable income certain deductions and tax breaks–called preference items–and pay the AMT if it is higher than the tax they would owe under the regular rules.
The AMT tax rate is 26 percent or 28 percent, depending on your AMT-calculated income and filing status. Unlike tax rates in the “regular” tax world, AMT rates are not indexed to inflation.
Ironically, the AMT is the closest thing we have to a flat tax, favored by many conservatives who are now demanding that the AMT be repealed.
One so-called preference item under AMT was extremely popular with executives of high-tech start-ups. Shares they acquired through so-called incentive stock options do not generate ordinary taxable income when the option is exercised–a generous tax windfall during the tech stock boom.
But the windfall is an AMT preference item, unless the shares are sold in the same calendar year.
Many companies, especially those making profits, avoid issuing incentive stock options. The windfalls they provide to certain employees at shareholder expense are not tax-deductible for the business, Simmons said.
But the options were a popular form of compensation in the heady days of electronic-commerce start-ups, which had no profits to shelter from taxes, he said.
Here’s an example of a likely scenario, thanks to Mark Luscombe, analyst for tax information publisher CCH Inc. in suburban Riverwoods:
In 1998, a high-tech executive received incentive stock options to buy shares in the fledgling company for $1 each. By March 2000, the stock had ballooned to $100 a share.
The executive exercised the option in March and cheerfully paid $1 for each share of a $100 stock. The instant $99 windfall is not reportable income under normal circumstances but is a “preference item” under the AMT.
Unfortunately, our exec held the stock and watched it sink to $25 in last year’s tech stock washout. If the stock was held into 2001 hoping for a rebound, the executive could face an AMT liability of up to $27.72 per share (28 percent of $99).
In other words, the taxes may be greater than the stock is worth.
If our exec lives in California, where high state and local taxes are preference items that must be added back for AMT purposes, chances are greater that the AMT hammer fell, Luscombe said.
But if our tech exec sold the stock by the end of 2000, he would have to pay capital gainstax on the difference between the sale price and the $1 purchase price, but that would be less than having the $99 option windfall being counted as an AMT preference item. What would you have done with your shares?
“You could stick ’em in a drawer, but the AMT makes you deal with your bad tech shares,” Bianco said.
If Congress goes along with Bush’s plan to reduce the 31-percent and 28-percent tax brackets to a single 25-percent bracket, thousands of unsuspecting taxpayers will face the AMT for the first time.
Incentive stock options, the best tax subsidy Silicon Valley ever saw, will become even less attractive for start-up companies hiring the next generation of high-tech whiz kids.
In the words of the new Dolly Parton song, they’ll be demanding “cash on the barrelhead, hon.”
Dumb question: What is a conduit IRA and who offers them?
Several readers asked this question after I mentioned conduit IRAs in my Feb. 4 column.
A conduit IRA is a mechanism permitted under federal IRA regulations. It is not a product or program of a specific financial institution.
Indeed, you may not hear about conduit rollovers from your bank or mutual fund company, because they represent interim accounts to hold money between two employer-sponsored retirement plans.
If you quit or are laid off and expect to receive assets from your 401(k) or similar tax-deferred retirement savings at work and also expect to land a new job at an employer with a qualified retirement plan, you may place the money in a conduit IRA holding account.
Later, when you get a new job, you may be able to roll the money with little fuss into the qualified retirement plan of your new employer.
Beware: You must not put conduit IRA money into an existing IRA or add new dollars to a conduit IRA, beyond the money the account earns. (For more, open the IRS web site, www.irs.gov, and search under “conduit IRA.”)
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In the belief that there is no such thing as a dumb question, send your queries to me at 435 N. Michigan Ave., Chicago, IL 60611; phone 312-222-3599; my e-mail is webarnhart@aol.com or bbarnhart@tribune.com.
