Posted: May 05, 2005 By: Gregory Randal Ralph

Subject: ISO AMT

Comment: Statement of:
Gregory Randal Ralph
Individual Taxpayer
To:
President's Advisory Panel
on Federal Tax Reform
Regarding:
Complexities and Unfairness of
Alternative Minimum Tax (AMT)
Applied to Incentive Stock Options (ISOs)
Submitted:
March 17, 2005


In the mid to late 1990s, I helped grow a company from an initial 11 person spin-off start up, to over 200 employees and over $100 million in annual sales as a leading supplier in the storage networking market. I was motivated and rewarded along with the other founders by Incentive Stock Options (ISOs) at pre-IPO prices under $1, which as Congress had intended helped fuel our entrepreneurial drive, created jobs, and added to the economy while encouraging our long term ownership in the company.
My experience with the AMT tax on ISO’s is that is that it contradicts and undermines the original intent of the ISO grants Congress implemented. In my case, the federal and state tax collectors have gotten 63% of my earnings, 20% of which is owed back to me as AMT tax credits. Although I have sold all of my stock, because of the nature of the AMT it is not likely the AMT tax credits will be fully returned to me in my lifetime, thereby becoming in effect a long term interest free loan to the government, with the balance forfeited to the government upon my death. Even with the return of the 20% owed to me, my combined federal and state tax rate would be 43% due to being forced to sell many exercised shares short term at regular income rates, in order to avoid additional larger AMT tax bills. This is completely counter to the Congressional intent of ISO options to encourage long term stock ownership. This tax is truly the most complex and unfair tax I could conceive of. The details of my experience and the confusion and adverse effects of this tax are described in the following pages of this statement.
In late October of 1999 when my company went public at $19, I could have exercised the 30% of my options I was vested in, but I was afraid to do so because I knew of the ISO AMT tax. I knew that in doing so I could owe on April 15th an AMT tax equal to about three times my annual salary on stock that I could not sell because of the IPO
lockup and possibly further insider trading restrictions. Since I had no way to pay an AMT sum of around $265,000 without being able to sell the stock, I instead exercised on January 1st 2000 at $66 while planning to hold for at least a full year. Now my potential tax bill was about ten times my annual salary, but at least I had until the end of the year to dispose of the stock at less desirable regular income tax rates and avoid the AMT.
In June of 2000, the same month my second child was born, I also exercised another 30% that vested that month at a market value around $50, which further upped the AMT ante. By the end of October 2000, one year after the IPO, I could have sold my first 30% for long term capital gain at over $90, and been set for life, had I not been afraid to exercise them at the IPO a year before because of the onerous ISO AMT. Instead, to achieve favorable long term gains, I now had to wait a few more months, form October 2000 to January 2001. Actually, I had to wait until the end of January, which was after earnings and the end of the company imposed insider trading lockup that started one month before the end of each quarter, in this case December 1, 2000.
After hitting a high of $126 in early November, the stock pulled back to $105, encountered a stunning $35 one-day drop, then ended the month around $50. With that kind of correction, I felt it was likely the worst was over and wasn’t likely to drop much more. In early December at the start of the insider trading lockout with the stock at $50-$60, I was not in any real AMT trouble having exercised at $50 and $66. However, in early December, Federal Reserve Chairman Alan Greenspan announced that his incessant interest rate hikes throughout the year had significantly slowed the economy and Vice President Dick Cheney lamented that “we may be on the front edge of a recession." Greenspan confirmed this at his December 19th. meeting, as he switched from a raising bias to a lowering bias, completely bypassing the step to a neutral bias.
(see BURSTING GREENSPAN'S BUBBLE : http://www.cepr.net/columns/weisbrot/bursting_greenspan_bubble.htm). After an initial rally, stocks plummeted as investors realized lower interest rates wouldn’t matter in the near term if the economy and corporate earnings were in recession. December 2000, the same month I closed escrow on the purchase of my first home, with Greespan’s comments, recession fears, and declining markets, my stock headed south and ended the last week of the year in the $20-$25 range. Clearly now I needed to sell to avoid excessive AMT tax on top of my market losses, but I could not sell due to the company imposed insider trading lockup. Actually, I now wish I had sold anyway and risked being a target of an SEC investigation and being fired by my company for insider policy violation. I think I could have handled a sentence of five months at the Martha Stewart insider trading country club and five months house arrest spending time with my wife and four children rather than dealing with the insanity of the AMT ISO tax and the IRS.
To conclude the saga, I exercised the remainder of my shares in January 2001 when the market price was $18, and sold before the end of the year for regular income gains at $10 to avoid more AMT. Finally in 2002, I sold my last share for a long term gain of a mere $2.65. We had lost the recession battle for industry market share, at which point I quit the company. Fortunately I had exercised and sold some shares in 2000 for short term gains, which combined with a second mortgage was enough to pay my taxes. My reason for selling was part diversification, house down payment, and to have the money to pay tax. Part of my reasoning for selling new shares short term rather than the previously exercised shares subject to AMT was the misunderstanding of the AMT tax whereby I thought the short term income would offset the AMT tax due, but actually it just pushed me farther into AMT and raised the overall tax. I am still glad I partially sold in 2000, or else I would now be in bankruptcy and without a home due to the AMT tax.
As it is, without the refund of my AMT tax credit to pay down my mortgages, I will be forced to sell my home as I can not afford to pay the increasing adjustable rate payments and property taxes which already exceed 50% of my gross income at today’s interest rates. This will likely mean changing schools for my children as well, which will be a terrible blow to my 6-year old who has a communication anxiety disorder which has prevented her in the past from speaking in class with her teacher and classmates. Only recently has she become comfortable enough in her surroundings to begin speaking with classmates, and my heart breaks to think of plunging her into a new unfamiliar school and back into debilitating silence. (see: http://www.selectivemutism.org).
How can a tax this complicated and unfair be in existence and be allowed to stand? It is truly complex and impossible to fully understand by lay people, and many tax experts as well. I tell you, I am an Electrical Engineering graduate from Caltech. I scored a respectable 1450 on my SATs. I consider myself to be reasonably intelligent, but even after researching the possible effects of the AMT prior to my ISO options exercise, and thinking I understood its implications, I found in reality it was more complex than I could have ever believed . I understood the ISO AMT was a pre-payment for future tax owed, and that it would generate an AMT tax credit that could be used in the future to offset tax. What I could not comprehend was that this credit would be nearly impossible to get back due to the twisted nature of the AMT tax. I think the fatal flaw most people make is applying their common sense to understanding of the ISO AMT tax, where in reality the ISO AMT tax is devoid of common sense. Common sense would tell you that if you have a credit of real money that you already paid in advance, you should be able to use that in full to offset any future liabilities. However, the AMT credit is treated as a reduction in your regular tax rather than a true credit, which can reduce your tax to the point you owe AMT and prevent you from using your credit. I was confounded by this as the large state tax deduction from the previous year ISO tax put me in AMT land the following year and prevented me from using any of my credit, but rather owing $129,000 more in AMT tax. How could I owe more tax when I had somewhere near $700,000 credit still not used? Why couldn’t I use AMT tax credits to pay my AMT tax, just like I would use previously paid estimated taxes to offset any tax owed? Additionally, you would think once the stock that the AMT tax was pre-paid on was sold, if any was credit was left over, it would be refunded at that time. Again, it would seem to be the common sense outcome, but not the outcome prescribed by AMT ISO tax. Instead, it turns into an interest free loan to the government for the rest of my life, as even using $10,000 credit per year will take 70 years get it all back. I hope to live to 107 years old to see that day, as I don’t believe the credit is transferable to my heirs. Better yet, I hope to see Congress do the common sense thing and pass legislation to repeal the ISO AMT and refund any outstanding AMT tax credit upon the sale of the asset that generated the tax. That would eliminate what I believe to be the most complicated and potentially unfair portion of the US Tax code. Repeal of the ISO AMT and/or refund of the AMT credit upon sale of the stock is the truly fair and honorable thing to do.