WINTER IN DISCONTENT OVER Alternative Minimum Tax
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Published Friday, March 16, 2001, in the San Jose Mercury News
Many running out of options
Unwary, unlucky punished by taxes on stock incentives
BY MARK SCHWANHAUSSER
Mercury News
For Angela Hartley, stock options offered the chance to quit a job that consumed 60 hours a week, spend more time with her 7-year-old son and bank away a retirement stash. Options were going to change her life.
They did -- but not as she had expected.
Just four weeks before the April 16 deadline, the 48-year-old single mother owes about $350,000 in income tax on the options she exercised, and her stock is now worth half that sum. Even if she sold all the stock and drained her 401(k) account and the equity in her 1,600-square-foot suburban home in San Diego, Hartley would still need to find another $175,000 or so.
She worries that she has little choice but to set up an installment plan with the Internal Revenue Service and pray her stock recovers in time to make payments.
Hartley and countless others who exercised incentive options to buy stock during the market's upswing have been caught in the downswing by the Alternative Minimum Tax -- a tax created to ensure the ``rich'' pay their fair share.
``I don't know if I could lose my house over this,'' Hartley says. ``I'm a single mom, and the idea of going destitute over this -- I can't imagine that was the intent'' of Congress when it created the Alternative Minimum Tax.
``I think there is this perception that it is only hitting Silicon Valley millionaires, and that it is just keeping them from buying a second home at Lake Tahoe,'' she said. ``People ought to be aware bankruptcy is possible for a lot of middle-class working people.''
`Financial disaster'
Some may sell homes, tap savings to pay bill
The stock market collapse has left many employees -- from the executive suite to the rank and file -- facing AMT bills based on long-gone paper profits. Some who exercised incentive options and owe the tax may have no choice but to plunder 401(k)s, sell homes, borrow from parents, arrange IRS payment plans and consider bankruptcy. Some will lie about what they owe and pray they escape an audit.
The AMT is based on paper profits on the day you exercise the option and buy stock -- even if the stock later crashes and you lose the profits. It's triggered when you exercise an incentive stock option in one year and hold the stock into a later calendar year.
The AMT applies to incentive stock options granted to employees, but not to the more common non-qualified stock options, which can be granted to both employees and non-employees, such as outside consultants. The two kinds of options have different tax consequences.
``This is an earthquake for these people,'' said Sharon Kreider, a certified public accountant in Sunnyvale. ``This is a financial disaster of the scope that hits when there is a natural disaster.''
The wreckage is evident in high-tech hamlets across the nation, but clearly Santa Clara County is at the epicenter. Here, one of every three households owns stock options.
At this stage, those hit hard by the tax can do little more than assess the damage and rage against laws they consider unfair. Although President Bush pushed his tax-cut proposal through the House, the question of overhauling the Alternative Minimum Tax has been tabled. Lawmakers have offered no relief to workers snared in the many tax traps surrounding stock options.
``There are a lot of people with six-figure headaches,'' said Rande Spiegelman, a senior manager of investment advisory services for KPMG in San Francisco. ``A lot of people working at those companies are still flabbergasted that it didn't work out.''
In hindsight, these workers all committed the same sin: They believed the stock market shared their faith in their companies.
Slumping stock prices
Accepted tax strategy ends up costing
You can count Hartley among them. She'd accrued options in previous jobs with other tech companies, but they'd never paid off. So it was a personal milestone when Hartley quit her job in investor relations one year ago and exercised incentive stock options with a paper profit of about $900,000.
Hartley and other option holders in this story asked that their companies remain unnamed because they didn't want to tarnish the company's reputation, degrade the value of their stock further or endanger severance packages.
Quitting her job meant Hartley had only 60 days to exercise her incentive stock options, but she was unfazed and optimistic. As March 2000 began, her company's stock had climbed to a record $128 a share, and she exercised her right to buy shares for just $5.25 apiece. The stock price had slumped to less than $100 by then, but she figured she was buying on yet another dip.
Following an accepted tax strategy, Hartley intended to hold her stock for at least a year to qualify for the lower tax on long-term capital gains. But she knew that holding her stock into another calendar year would trigger the Alternative Minimum Tax, which in her case was $350,000.
The AMT is a pre-payment of tax, and some taxpayers who pay the AMT can recoup by claiming an AMT credit in future years. But the process can take years, and some never break even.
``When stocks drop like this, you're much less likely to recover your AMT credit,'' said Ellie Kehmeier, national tax director in Deloitte & Touche's technology and communications group in San Jose. ``This is where you're adding insult to injury.''
As Hartley and others now painfully realize, the biggest risk is owing the tax even if the stock crashes. And Hartley's stock did crash, plummeting below $30 in December.
At that point, Hartley faced a difficult decision. She knew she could walk away from the AMT tax if she sold her stock by the end of 2000. She'd owe income tax at rates as high as 39.6 percent, but at least she'd be taxed only on actual gains, not the initial paper profits.
Hartley considered that a defeat. ``I thought about it often. But I was so confident that if I just hung in there, the stock would come back up.''
She was wrong. The stock has skidded below $16, not even enough to pay half her AMT bill. She feels she has no choice now but to hang onto the stock and hope it rebounds in time to pay her tax bills.
``The irony,'' said Hartley, thinking back on her worthless options from past companies, ``is I will lose almost everything I have worked for due to the only stock I had that went up.''
One thing is clear about stock options: Too many people know too little about them. An OppenheimerFunds survey last year indicated that 75 percent of stock-option holders weren't familiar with the Alternative Minimum Tax, and that 52 percent knew ``little'' or ``nothing at all'' about the tax implications of exercising options. More than one in three couldn't say whether they held incentive stock options or the more common non-qualified options.
One Santa Cruz middle-management engineer, who didn't want to be named for privacy reasons, was oblivious that she owed the Alternative Minimum Tax until weeks after she'd exercised her options, when her partner was reading the Mercury News. Doing some quick calculations, they figured she owed $98,000.
Panicked, she phoned a CPA, who told her she actually owed $355,000. That's roughly twice what her stock is worth today.
The engineer desperately wanted to dump her stock in 2000 to sidestep the AMT. But she couldn't because she was ``locked up'' until 180 days after her company's initial public offering.
Stunned, she asked her company to take back her stock in 2000. ``I was begging them, groveling. They said they couldn't.''
As the April 16 tax deadline closes in, she fears she must tap her $120,000 in home equity, an $88,000 401(k) and $35,000 savings.
``I don't know what choice I have. I feel devastated,'' she said. ``If I had known this would happen, I never would have done this.''
She has consulted other tax advisers. Among the advice: Calculate her AMT bill based on the first day she was allowed to sell her stock, rather than the date she bought the stock. That would slash her tax bill but might not withstand an audit.
Acknowledging that she's contemplating audit roulette, she said, ``That's what scares me. I'm battling with myself every day.''
Kelly Michael Stewart suffered a similar fate, even though he wasn't restricted from unloading his stock in his Nashville e-learning company in December to avoid a tax bill worth ``tens of thousands of dollars.''
Buying back stock
Financial, ethical trap blindsides tax pros
The problem was something he didn't anticipate. ``The volume for the company was so low, the amount of shares I had to dump would have sent shares plummeting,'' said the 34-year-old father of two boys. ``I ended up not being able to dump any, or at least not enough to make a difference.''
Of all the stock-option bombs to explode this year, one kind stands apart. In Ho Lee is in a financial and ethical trap that blindsided even the tax pros.
``It's sobering,'' said the 28-year-old Atlanta man, who faces about $100,000 in taxes on stock worth about $60,000. ``Everything I have done is completely irreversible. I'm going to have to pay this, one way or another.''
Lee exercised options to buy stock in 2000, then dumped his stock late in the year to avoid an AMT bill. But he took one extra step -- he bought back the stock immediately, confident it would rebound.
That wouldn't be allowed if these were ordinary shares of stock. Well-publicized ``wash sale'' rules stop taxpayers from chucking an investment to claim a tax loss, then rebuying the investment right away. But it wasn't clear -- some tax pros contend it still isn't -- whether these rules apply to incentive stock options. It was a question few had contemplated because it didn't come up during the bull market.
But as clients lined up to dump their stock in the waning days of 2000, tax pros dug into the tax code. Influential experts concluded that the rules do apply to incentive stock options -- and advised their clients against buying back the stock.
Lee didn't hear about this new interpretation until it was too late. To pay his $100,000 in income taxes, the disciplined saver is anxiously sizing up his various nest eggs. Besides tapping his $150,000 in home equity, he might sell other depressed investments or exercise and sell other stock options as they vest each month, though he dismisses this as ``spitting on a fire'' at today's stock price.
``I've certainly replayed this in my head umpteen times,'' Lee said. ``There are times when I think, `Yeah, I was too greedy.' And there are definitely times when I think I was financially reckless. . . . It was kind of an infectious group optimism. Everyone was almost dreaming aloud and saying, `We're on this rocket ship, aren't we all lucky to have caught this ride?'
``We were going through those highs in the last year and being able to dream the whole dream of financial independence,'' he added. ``Now, we're waking up, and it's all gone.''
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Contact Mark Schwanhausser at mschwanhausser@sjmercury.com or (408) 920-5543.
