FINANCIAL PERSPECTIVE: INCENTIVE STOCK OPTIONS LOSE WITH NEW TAX LAW! By Alan Ungar For anybody who has Incentive Stock Options, the law of unintended consequences certainly reared its ugly head when Congress lowered the Capital Gains rate to 20% from 28%. The problem is that anybody who exercises ISO’s and holds on to them for 18 months still pays 28% instead of 20% capital gains. Ken’s case illustrates the problem. He works for a high tech firm and some time ago was granted options on 16,000 shares at 37 cents. His goal is to diversify his portfolio so that his total wealth is not with one company. He wants to do it in the most cash efficient and tax efficient way he can. Table 1 illustrates his problem. Description Old Law New Law Amount of Tax Preference $354,080 $354,080 Alternative minimum tax at 28% 99,142 99,142 Capital Gains Tax Due at Time of Sale 99,142 70,816 Tax Offset (Max Minimum Tax Credit Allowed) 99,142 70,816 Tax “Overpaid” $ 0 $ 28,324 In English, at the time you exercise a stock option it is subject to an Alternative Minimum Tax of 28% on the difference between the exercise price and the market price at the time of exercise. Under old law, that total amount was fully credited. Under new law, the full amount of AMT is not credited, so Ken pays at 28%, not 20%. Should he sell the stock immediately and pay the higher ordinary income tax? From a tax standpoint the answer is definitely no. On the other hand, he has to finance the AMT and he wants very much not to be so vulnerable by holding just one stock. The answer would be a no-brainer if he paid 20% capital gains instead of 28%. But, he should not be faced with this dillema in the first place. The problem needs to be fixed! And it can be! The solution is easy! The problem has surfaced because there is a flaw on IRS form 8801 and because the AMT rate is 28% instead of 20%. To fix it, the IRS has to change its instructions on line 2 of form 8801 so that a negative number on line 9 of the prior year is picked up—or in the Technical Corrections act, the rate of AMT is changed to 20% from 28%. Getting the powers that be to make this fix is not so easy. When we talked to the Ways and Means committee the answer was,”that is a forms problem you need to call the IRS.” NOT! This is an American problem! ISO’s have contributed immensely to our productivity. This incentive needs to be encouraged not discouraged! After peeling ourselves off the wall and restoring our equanimity, we asked “So who do we call at the IRS?” “Don’t ask me,” said the bureaucrat!” Gag us with a spoon! So we decided not to ask him. Instead we called Brad Sherman, our congressman and Brad’s people got on it right away. However, more pressure needs to be applied,the old “the squeaky wheel gets the grease” maxim holds. You can help by contacting your congressman or writing to Chairman of the Ways and Means Committee, Bill Archer, 1236 LHOB Washington D.C. 20515,or Fax him at 202 225 4381. Just ask him to make the changes talked about above. There is a deeper question. Why should ISO’s be subject to the Alternative Minimum Tax? What happens if the stock price goes down after exercise? Taxes for anticipated profits have been paid in advance and those profits are not forthcoming. Why should tax payers have to finance their AMT create “opportunity” losses because the taxes are paid with money that could have been invested? ISO’s should not be subject to Alternative Minimum Tax,and you can help get this changed too! Just call or write those same congressmen and tell them what you think. Your actions will very definitely make a difference. In the meantime, be careful about exercising those stock options! Alan B. Ungar is President of Financial Counsel, a fee-based Financial Planning and Investment Management firm in Calabasas. He is Co-Chair of VICA’s Federal Issues committee and is the Valley chair for the Concord Coalition.