Taxing unseen profits
High-tech employees are getting smacked with exceptionally large tax bills this year because of a collision between how stock options get taxed under federal law and the slide in the stock market.
Under the Alternative Minimum Tax, tech workers who purchased options in 2000 but didn't sell them that year have to pay taxes in 2001 on the shares' value on the date they were purchased--even if the stock has since plummeted, as so many did in the last year. Many people are paying taxes on what are now worthless options.
Some executives are looking at tax bills of over $3 million dollars, according to Sandy Murray, partner at Burr, Pilger & Mayer, an accounting firm in San Francisco. Ordinarily, such a high tax bill would mean that the person in question already pocketed nearly $9 million in capital gains.
Unfortunately for executives, though, that's not the case under the AMT. If someone bought and held his or her stock options, the actual gain, measured in stock value, might be a few hundred thousand--not nearly enough to pay off the tax bill.
"People are taking out home equity loans to pay off their taxes," said Chris Larsen, CEO of E-Loan and a member of Pac.com, a lobbying group that will propose changes to the law this summer. "In a worst-case scenario, people thought they were going to be at zero."
One executive "made" around $615,000 in early 2000 by purchasing options when the stock was trading around $90, said Larry Jacobs, a principal in Jacobs and Montgomery, an Oakland, Calif., accounting firm. But the executive didn't unload the stock and now faces a tax burden that exceeds his income for the year.
"I estimate it cost him about $190,000 to go to work last year," Jacobs said.
The AMT nightmare
The Alternative Minimum Tax was originally created to prevent wealthy people from avoiding taxes on extraordinary forms of compensation. The provision, for instance, is used to tax outright grants of stock or cars given as part of a compensation package.
Gains from stock options fall within the provision. However, the "gains" garnered through stock options are calculated in an entirely different manner than gains from ordinary stock transactions.
Under AMT, the IRS taxes the difference between the strike, or purchase, price of the option and the market price on the day the option is bought. With ordinary stock, the IRS imposes a tax only on the difference between the purchase price and the eventual sale price.
The difference in the calculations is where the nightmare exists. Say, for example, a person bought 10,000 options at $9 a share in 2000 when the stock was selling for $100. Subsequently, the stock plummets, and in 2001 the person sells the shares for $2.
Under AMT rules, the IRS says the person had a gain of $910,000, not a $70,000 loss, because they had constructive control over the options during the high period. It's like getting a summer home as a bonus that gets burned down later by accident. In the end, the person will be out about $406,000 in stock losses and AMT tax owed.
Doug Galen, general manager of eBay's real estate division and a former E-Loan employee, said he was hit in 2000 and again this year.
"After we picked ourselves off the floor, my wife and I decided we would not exercise options until we were going to sell them," Galen said.
Option holders can avoid AMT liability by selling or rescinding the options in the same year. Jacobs also pointed out that excess AMT payments get used as credit against capital gains in subsequent years. But the size of some AMT debt means the credits will never fully be used.
"Some people will have eternal carry forward that will be with them until they die," Jacobs said. "When you get hit with AMT, you owe a whole bunch of tax now."
That was the case with Galen: "I've had to pay AMT taxes that I will never get back. I'll never get my money back from the government."
Like others, Galen said he "didn't fully appreciate the AMT issues" until it was too late.
Another problem with AMT is that it hasn't been indexed for inflation, Jacobs said. AMT was originally designated to apply to only the wealthiest taxpayers, but the income rates at which it kicks in were set 30 years ago. Both he and Larsen agree with the intent of the law; it's the application that smarts.
"Generally speaking, AMT is a great idea. It prevents a lot of rich people from avoiding taxes, but there are some quirky things in it that are hitting midlevel people," Larsen said. A number of E-Loan vice presidents have been affected, he added.
The really wealthy of Silicon Valley--company founders and venture capitalists--aren't affected by AMT because they obtained their stock in outright grants, not via options.
Lobbying for change
Pac.com wants the law changed so that the tax liability isn't triggered until the options are sold. Shifting the payment trigger from the purchase date to the sale date would also encourage long-term investing, members say.
Pac.com members plan to meet with congressional representatives to lobby for the changes, said Wade Randlett, vice president of Sigma Storage.
"You really have a pretty significant distortion," Randlett said. Some people took out loans to buy the options in the first place and now have to pay off those loans in addition to a tax bill on money they never even made. "Those guys are screwed in every way possible," he said.
Last year, Rep. Jim Boehner, R-Ohio, submitted a "Super Stock Options" bill that would have moved the trigger date and taxed option gains from certain companies like regular stock purchases. Reps. Cal Dooley, D-Calif., and Adam Smith, D-Wash., have also shown support for relief.
Still, "there's not a lot of sympathy in the other 49 states for Silicon Valley," Burr, Pilger & Mayer's Murray said.
Until the law changes, there are not many good options for how to pay off AMT debt. IRS debt can't be discharged in bankruptcy, and taxpayers either have to pay off the entire amount or agree to a five-year payment schedule, with interest.
Taxpayers can also try to obtain an offer and compromise, "but that is a final step before they put a levy on everything you own," Jacobs said.