Subject: ISO-AMT Reform Comment: Submitter's name: Stephen S. Jackson Date of submission: March 18, 2005 Contact Information: P.O. Box 13356 Research Triangle Park, NC 27709 Category of submitter: Individual To Whom It May Concern: This letter regards the provision of the Alternative Minimum Tax (AMT) rules as applied to the Exercise of qualified Incentive Stock Options (ISO). This letter is organized into several brief sections, beginning with an overview of the ISO-AMT law, and then explaining this law’s Inequity of Asset Valuation, the Distortive Effect on Transaction Timing, and Dilution of Congressional Intent. Left unchecked, general public awareness of the gross inequities of this law could quickly undermine voluntary compliance, to the degree that overall tax code enforcement would become impossible. Overview: AMT as applied to ISOs When an ISO is exercised and the fair market value at the time of exercise is in excess of the option strike price, the difference between the two is a Preference Item, and the amount is used in the calculation of the individual Tentative Minimum Tax (TMT) liability. If TMT is greater than the individual taxpayer’s regular tax liability, the TMT become an Alternative Minimum Tax, and the higher levy is due. Economically, the AMT provision regarding the TMT Preference Item of an ISO exercise (and the calculation behind it), serves two purposes: One is a desired purpose - the individual taxpayer is not able to arrange for employment compensation (in the form of incentive stock options) such that income derived from the gain realized would be exempt from income taxes. The other purpose is undesired - the law, as currently written, excises a pre-payment of capital gains assessment on a gain that may never be realized, and the resulting capital-gains tax credit has no official mechanism for recovery under AMT rules. (Indeed, IRS does not even publish a form or instructions for an AMT Schedule D.) The credit recovery mechanism exists, for all practical purposes, only on “the regular tax side of the ledger.” Inequity of Valuation TMT income is realized by the taxpayer upon the exercise of the ISO, which is the process needed to ascertain value and required to manifest the “desirable” outcome of the ISO AMT tax calculation as described above. For the majority of taxpayers who are granted ISOs and who exercise them “in the money,” the cash needed to satisfy the resulting capital-gains tax prepayment would have to come from the sale of the ISO on the open market, or, from a loan against the value of these securities. That is to say, the majority of such optionees do not have the free capital to pay the significant amount of tax due on the transaction. Moreover, the actual amount of tax due is a relatively complex calculation, and can often only be accurately computed using the figures available at or near the end of the tax year. (Please refer to “Distortive Effect on Transaction Timing” below.) Because the TMT calculation is only a “guess” of future capital gains tax liability, the “guess” gets based on the net value of the paper gain as of the date of exercise. Discounting the TMT standard deduction, the tax amount is roughly 200% of the capital gains tax that would be due if the underlying security remained at the fair market value (FMV) upon ISO exercise. A decline in FMV compounds this terribly inequitable mis-evaluation. Herein is the first major valuation problem with the law, as written. The valuation date for TMT preference income is the date of the ISO exercise, resulting in an inherently inaccurate figure according to recently-enacted GAAP rules for corporate treatment of ISO valuation. The second major valuation problem with the law is that, absent any other TMT Preference Items, the tax calculation of 26% - 28% of the imputed ISO gain will be significantly more than the actual future tax due, for which the AMT is a prepayment. Today, the long term capital gains tax rate is 15% of the capital gain upon sale. The result is a nearly 200% inflation of a pre-payment of a tax which may never be due. Distortive Effect on Transaction Timing Investment decisions should be made, in general, without direct regard for the tax consequences of that investment decision. Tax implications should at worst be a secondary consideration, or else the amount, timing, or trigger event of the tax is onerous and should be reconsidered. While a sizable debate can be made about the distortive effect of any capital gains tax at all, any related tax law that triggers an entire parallel and conflicting set of taxation rules is beyond the limit of reasonable discourse. Such is the AMT treatment of ISOs. Because so many ISO holders depend on the value of the underlying security to derive the funds for which to pay the AMT levy, the taxpayer is put into a “shell game” of timing “gotchas” with respect to the exercise date, holding period, LTCG time limits, ISO vesting periods, trading restrictions, and disqualification period limits. Accurate calculation of a taxpayer’s TMT can often only be done near the end of the tax year, while most tax experts would recommend that ISO exercises be made early in the tax year. This is a most troublesome conflict by itself, and does not account for the effect of exercise timing versus market price, for minimum TMT impact. Moreover, if the underlying security drops in value after the exercise, the taxpayer can easily be forced into a situation where a sale-at-loss is mandatory, simply to avoid unfunded tax liabilities. When considering that the tax on ISOs is a PRE-PAYMENT of a tax that MAY NEVER BE DUE, the distortive effects of ISO AMT on purchase and sale timing is the most egregious transaction timing effect in all the US Tax Code. Dilution of Congressional Intent It is the clear will of the Congress that ISOs be a mechanism to foster employee ownership. It is well-known and demonstrable that employee-owned firms exhibit better morale, lower turnover, and greater productivity than their absentee-owned peers. Today’s ISO AMT rules clearly work against this goal of employee ownership, by creating risk scenarios that pose more peril to the taxpayer than their risk of capital loss. |