Options dream turns to nightmare

Taxing profits unseen

Braybrook, a 25-year-old San Francisco resident and one of the first employees at e-mail hosting company Critical Path, recently found out he owed the federal government roughly $280,000 in taxes on stock options that he never converted into cash. Braybrook can't afford to pay the so-called Alternative Minimum Tax (AMT) because the stock options he still holds in his former employer's stock are practically worthless and he doesn't have a spare quarter-million dollars in savings.

"Let's just say I had an absence of tax advice last year," the dual citizen of Canada and the United States said wryly. "There's absolutely no way I can pay. I find it difficult to think I could go to jail over tax on money that I never had. It's sort of darkly humorous--it's a joke."

Unfortunately, a growing number of taxpayers--especially stock options-holding technology workers--are not laughing. Because of the relatively obscure AMT, tech workers who exercised options to buy stock 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.

That means many people owe taxes by Monday's deadline on what are now worthless options. Some executives are looking at tax bills of over $3 million, according to San Francisco-based accounting firm Burr Pilger & Mayer.

The AMT was originally crafted as a way to wring money from rich people who were becoming increasingly creative about tax shelters in the 1970s and 1980s. Simply defined, the AMT is a recalculation of income taxes to a formula that is far less favorable to the taxpayer than ordinary income tax. For example, it typically doesn't allow deductions for dependent children or certain costs associated with purchasing a home, and it blurs some distinctions between paper and actual wealth.

Kaye Thomas, an expert on the AMT and author of stock option guidebook "Consider Your Options: Get the Most from Your Equity Compensation," estimated that about 1.5 million people will pay the AMT for 2000 income and the number will mushroom over the next decade if the Internal Revenue Service doesn't change its guidelines, in part because of the increasing popularity of stock options.

"Without any changes in law, by 2010 we'll have 17 million people paying AMT," Thomas said. "They're relatively middle-class people--upper-middle class, but not highly wealthy people, and many have large families. They get stuck in the AMT because they can't claim personal exemptions. Especially homeowners, people in high income-tax states and people with large families will be hit."

Push to repeal AMT
Legislators in California's Silicon Valley, ground zero for the groundswell of stock options during the late 1990s bull run, say angry constituents want to repeal the AMT. On April 6, some Democratic lawmakers from California began pushing legislation to provide retroactive relief for people who exercised potentially lucrative stock options in 2000 but face painful tax bills on evaporated profits.

If the bill passes, workers who exercise incentive stock options would be taxed on actual gains from selling stock--not paper profits.

But tax experts are calling the initiative a long shot. The government isn't likely to change a provision that affects option holders--still a relatively minute portion of the taxpaying public. And legislators outside of Silicon Valley and other tech hubs aren't likely to look upon new members of the AMT club with sympathy.

"These same people who are saying, 'Gee, I got burned really badly' made a ton of money in the past years," said Claudia Hill, owner of Cupertino, Calif.-based Tax Mam/Tax Services Group. "I agree there should be a provision that if they never realize the gain they won't be taxed on it. But will there be retroactive relief? In our dreams."

Hill and other tax specialists said that people who legitimately cannot afford to pay the AMT because their options are worthless may be able to negotiate a compromise with the government. The IRS will consider such negotiations on a case-by-case basis.

A break from the IRS?
In a small number of cases, the government may reduce a worker's tax burden if he or she has no record of tax fraud, has already sold the worthless options and does not have a large savings to pay the AMT. But the government isn't likely to have much sympathy for someone who is still clinging to the unsold stocks and the notion that they will eventually rebound, Thomas said.

And even if the government reduces or eliminates a taxpayer's burden, it won't erase the bureaucratic nightmare that will accompany it. Compromise negotiations typically translate into a complicated auditing process that lasts for a year or more, involving a prodigious paper trail and time-consuming meetings with federal officials.

"There are choices for people in a pickle," said Michael C. Gray, a San Jose, Calif.-based CPA and founder of the Employee Stock Option Advisors Association. "There's a good chance they may get out of it, but it could take years and it would be an enormous headache."

Legislators' efforts are likely to be of little immediate help for Braybrook, who has already hired an accountant and hopes to negotiate a compromise offer with the government. Braybrook received 10,000 options when he went to work Critical Path as employee No. 6.

Critical Path went public in March 1999, and the stock took off with that of other Internet-related companies. Within a few weeks, it hit $150.25, and Braybrook--who had pre-IPO options at pennies per share--was theoretically a multimillionaire.

He exercised and sold some options in 1999 to pay off $20,000 in debts and pay for his 1999 Volkswagen Jetta. He exercised the rest in early 2000, including one group of options whose fair market value had reached $95 per share. He had exercised all of his stock by March 2000, when he resigned.

Option holders may "exercise" their shares by buying them from their employer at a pre-fixed "strike" price--often dramatically lower than the fair market value at the time they're exercised. The holder may then sell the stock on the open market and pocket the difference between his strike price and the fair market value at the time of the sale.

Market surprise
Braybrook planned to cash out the exercised options and enjoy his wealth, but he sat on the shares in hopes they would float further.

A month later, the stock market collapsed. Critical Path began a rapid descent.

When the stock started to tumble, Braybrook watched his paper wealth shrivel--but didn't sell the stock because he maintained hope that it would rebound. (Other options holders now facing the AMT held onto their stock because they were hoping to pay as little as 20 percent in long-term capital gains tax if they held the stock for at least a year, instead of as much as 39.6 percent in regular income tax if they sold it immediately after exercising the options.)

Braybrook said he was vaguely aware of the AMT and knew that he had to sell the stocks by the end of the year or else pay the increased tax. But he hadn't calculated the tax and wasn't expecting anything near his $280,000 tab.

"I had an idea that something bad was going to happen in December when I was looking at my taxes," Braybrook said. "I figured I'd let it ride--it was just another gamble. I figured at the worst I'd just sell it at $30."

The stock never recovered. In fact, it began an even more rapid slide in early 2001. The San Francisco-based company announced in February it was under investigation by the U.S. Securities and Exchange Commission for its accounting practices.

Critical Path shares are now trading around $1, compared with a 52-week high of $87. The company recently fired President Diana Whitehead and sales leader Mari Tangredi, cut 450 jobs and announced it would close offices not involved in its core e-mail hosting business.

Braybrook is bitter. Now working as an information systems manager for a chemical company in Palo Alto, Calif., he vows never to work at another Internet company.

"I never want to work in another Internet company again," the native of Niagara-on-the-Lake, Ontario, said. "The proportion of people who had a clue and those in it for the ride got out of control."

As for his debt with Uncle Sam, Braybrook plans to offer what he can but hopes that the government will let him off in full.

"I don't expect them to have any choice but to let me off," Braybrook said. "You can't squeeze water from a stone."