Victims of the alternative minimum tax quirk that taxes nonexistent income of incentive stock options when the stock loses value received a welcome holiday gift from Congress.As one of its final actions before adjournment, the 109th Congress passed the Tax Relief and Health Care Act of 2006, one of the provisions of which includes a scaled-down version of legislation originally sponsored by Rep. Sam Johnson, R-Texas, to fix the problem at the intersection of the AMT and stock options. The new law provides relief to many victims by accelerating the refund of stranded ISO overpayment credits that, under previous law, would not be returned within the taxpayer's lifetime.
Under the regular income tax rules, incentive stock options are not taxable at the time that the option is granted or when the option is exercised. However, the spread between the option price and the fair market value of the stock upon the exercise of the ISO is income under the AMT. Taxes paid on these phantom gains were pre-paid taxes and were supposed to earn the taxpayers pre-paid tax credits against future tax liability. However, because the law never worked as intended, the pre-paid credits earned have not been usable. The new law will rebate the pre-paid taxes over a period of roughly five years.
For example, under the old AMT scenario, if an employee exercised an ISO to buy 2,000 shares at $10 a share, the employee paid $20,000 for his stock. If the market price is $100 per share, the $90 spread produced $180,000 of paper gain that was included in income for tax purposes that year. At a 28 percent tax rate, the tax on the paper gain would be $50,400. If the price of the stock fell from $100 to $25, the stock would be worth only $50,000, and, if sold, would not cover the taxes due on the paper gain that never materialized.
The tax on nonexistent income came as a surprise to many workers who received either no advice or wrong advice on the tax implications of options, according to Jay Cena, congressional committee chair of ReformAMT.
"These are not the wealthiest people," Cena emphasized. "Many of them come from ordinary backgrounds. They just happened to get the wrong advice at the wrong time. They would have been better off if they had never received incentive stock options."
For example, he cited Janine Valdivieso, who worked as a correctional officer for various government agencies until 1999, when she took a job at Symyx in the private sector. "She accepted a lower salary than she had wanted because the company offered ISOs," according to Cena.
"Janine and her husband Joe were told by their employers that they would not be impacted by the AMT as long as they held on to the stock and did not sell during the same year.
This was not only incorrect, it was financially devastating for them," said Cena. "They ended up owing over $100,000 in AMT, in addition to the nearly $25,000 in regular tax they paid. This was more than their combined annual income."
Similarly, Ronald Speltz thought that his employer was doing him a favor by issuing him ISOs to augment his salary, which was about $70,000 a year. Instead, the stock options triggered a tax nightmare when he exercised them before the tech bubble burst, leaving him with nearly worthless stock but with an unexpected tax bill of close to $225,000.
Although Speltz and his wife borrowed $134,000 to help pay state and federal taxes, and offered the cash value of his life insurance policy as a compromise for the remainder, the Internal Revenue Service rejected his offer.
The Tax Court agreed.
Even though the offer-in-compromise provisions include a compromise to promote "effective tax administration" - explained by the regs to cover situations "where collection in full could be achieved but would cause economic hardship" - the court found the Speltzs had sufficient income to meet "basic living expenses," and therefore didn't qualify. Although the court said that it sympathized with their situation, it was up to Congress, not the courts or the IRS, to come up with a solution.
Speltz and his wife were invited by the White House to attend the signing ceremony.
"I was astounded and very honored that we were invited for the signing," said Speltz. "The passage and signing of this legislation restores our faith that our system of government works, and that common people being wronged by the unintended consequences of a law can have their voice heard on Capitol Hill."
However, he noted a number of flaws in the bill that he hopes will be corrected in the next Congress.
"It will be 2008 before we get anything back, and we need it now, not in 2008," he said. "Even though the government will be trying to give our money back to us, the bill doesn't tell the IRS to stop collecting. And although the phase-outs won't affect me personally, it's still wrong to tax someone's income 300 percent above a certain income level."
NOT COMPLETELY FIXED
The new law is not perfect, agreed Tim Carlson, the attorney for the Speltzs and president of the Coalition for Tax Fairness.
"They put in the phase-outs at the last minute, so if you make above a certain amount, you don't get any relief," he said. "That provision was not in the original bill that had 60 cosponsors, so no one had a chance to analyze what the phase-outs might do. In fact, there's so much incentive to get the credits back that it will encourage some to make less money. When you do a cost/benefit analysis, you have to ask whether you want to be productive and let the government keep your money, or adjust your salary and get back what the government never should have taken. The incentive structure is so high that a lot will be tempted to retire early, or work part-time and do some volunteer work."
The new law also does not address interest and penalties, according to Cena. "In some cases, these have outstripped the original principal," he said.
Nevertheless, said Cena, "It's a huge win. It's not a red state-blue state thing, it's in every state. Our members come in every shape and size. One killed himself, one died of cancer and her husband inherited the issue, and numerous people have lost their homes. Now, many of these people will be able to begin putting their lives back together."
"The AMT elephant will have to be remedied a bit at a time," Cena said. "This was the right first step, since there was no one hurt more egregiously in AMT than the folks who got stock options."
Two steps remain, according to Rep. Johnson: Addressing ongoing liability, interest and penalties being assessed on tens of thousands of taxpayers across the country, and extending the relief to all families, regardless of income bracket.
"This AMT-ISO situation demonstrates once again why we should repeal the AMT altogether, but this particular problem deserves attention now," Johnson said. "I'm glad that we took the first bite of the apple and got to help the rank-and-file employees hurt by the AMT-ISO inequity. I hope that we can build on that success and next year end this problem for everyone."
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