Subject: ISO-AMT through a CEO's eyes Comment: Presidents Advisory Panel on Federal Tax Reform Washington, DC Dear Chairman and Panel Members: My name is Nield Montgomery. I very much appreciate the opportunity to tell my story of suffering and hardship brought on by the application of the out of date and destructive rules for the treatment of Incentive Stock Options under the Alternative Minimum Tax (AMT) code. My difficulties and those of thousands of others were brought about by events never contemplated when the AMT was devised, i.e., the significant negative tax impact that happens with stock options when a company’s stock price experiences a dramatic decline. At the risk of being too basic, please allow me a brief explanation of stock options. A stock option is the right to buy a share of stock at its current price (the strike price) at some time in the future. Non-Qualified Options (NQOs) and Incentive Stock Options (ISOs) differ in their tax treatment. I’ll talk first to ISOs. When the option holder exercises the right to buy (obviously the current market price exceeds the strike price), they create an Alternative Minimum Tax (AMT) taxable event. The AMT treats the spread between the option strike price and the stock price when the option is exercised as income (otherwise called “phantom” income). That is, even though there’s no tangible income, a tax consequence occurs non-the-less. Now to be fair, when the AMT exceeds the regular tax owed calculation, the taxpayer gets a credit against taxes in future years (the credit’s application is complex and can take years if ever to recover). A subsequent sharp decline in stock price does not alter the tax owed even if the stock price goes to zero. When the tech bubble burst, huge numbers of share owners were left with tax bills resulting from the AMT treatment of ISOs while their shares had become nearly or even totally worthless. Remember, the real value of the stock has nothing to do with taxes owed. What was supposed to be an “incentive” and accepted in lieu of cash compensation turned into a tax nightmare (an obligation to pay taxes where no income/gain was realized). People were forced to mortgage/sell their homes, take out loans, or sell what ever they could to pay these absurd tax bills. It seems incomprehensible the IRS would enforce such harsh collection measures for tax dollars that become a credit in the taxpayers account. This AMT tax treatment is complex and unfair and has caused untold financial hardship, ruin, and heartbreak. Side note: how does the government account for these prepaid taxes? The tax treatment for NQOs is even worse. Tax law requires the treatment of the NQO as an income event at the time of grant. The income results from the difference between the strike price of the option and the stock price on the grant date. This is without regard as to whether the NQOs are even exercised and, if they were, whether or not the shares were sold. Again, in a market such as we’ve experienced, a decline in the price of the stock is just a personal misfortune. The tax is owed even if the stock price goes to zero. Looking at the larger picture, I’m not sure anyone can assess the positive impact the awarding of stock options has had on our economy. I know their use has been wide spread and it’s my opinion they’ve been a significant factor in holding down wages and inflation. Thousands of employees had been willing to accept below market wages in exchange for options. The belief was that by working hard and making their company a success, they’d have a share of that success. Unfortunately, for many, it didn’t work out that way. If the negative tax treatment of stock options isn’t fixed, their use as an incentive and benefit on holding down wages will be lost. Now for my story. By way of background, I worked 31 years in the telephone industry starting at the lowest entry-level job and working my way to General Manager. In 1993, I left a good paying job to become and “entrepreneur”. Two years later, I founded MGC Communications. Having worked my entire career in large impersonal corporations, I thought it was important that our employees be owners as well. We accomplished that goal by granting stock options to everyone who joined the Company. At the most senior level, we were able to hire very qualified people at compensation levels below market rates by sweetening employment packages with stock options. As a young Company, it was essential we conserve our cash. Since salaries and bonuses represented such a significant portion of on-going cost, the use of ISOs was an effective way to do that. ISOs also incented our employees, as owners of the Company, to really apply their talents to building the business. As the most senior officer/leader of the Company, I was committed to and embodied these goals. In lieu of a salary more typical of my position (my successor’s annual salary was $500,000), mine was $150,000 with ISOs as additional compensation. In lieu of cash bonuses (my successor’s annual bonus was $500,000), I took ISOs. Little did I know of the tax nightmare lying ahead. Unlike many victims of this cruel conspiracy of events, I had access to good tax planning help. My personal banker was with one of the largest public stock firms in New York. When he didn’t have answers, he had the best talent available to him in the corporate offices. My accounting firm was one of the big five national firms. Like my banker, when they needed help, they turned to specific experts on their corporate staff. Yet with all this knowledge and talent, none of them really understood the complex treatment of options within the AMT. Here’s what happened in my case. When I exercised my options in early 2000, the stock priced was $66 per share. Since the options had been granted in the early days of the business, the strike price for the options was very low. When the spread was calculated and the AMT rules were applied, I owed an additional tax of $4,400,000. Within six months of exercising my options, the stock had lost 90% of its value (the Company eventually declared bankruptcy). While the intended holding period for ISOs is one year, I was forced to sell shares sooner to raise the money to pay the taxes. To further compound the situation, I owed taxes on the shares being sold. In the end, I sold all the shares acquired thru options to pay the AMT and still ended up $200,000 short. I have said many times jokingly, if the IRS would have accepted everything I owned in the Company in exchange for the AMT owed, I would have been money ahead. All I have to show for founding the Company, creating thousands of jobs and building a good business is a substantial tax bill; a tax bill that resulted from a purchase event. I understand and accept the tax consequences when there’s a purchase and sale which results in a net gain. What I reel at is the application of a 28 percent tax on the purchase of stock as though some form of gain had been realized. This is a virtual sales tax! And, as noted earlier, the tax code is so complex it was/is impossible to find anyone sufficiently knowledgeable to provide accurate tax planning. As I’ve talk to other people similarly situated, I’ve realized how pervasive this problem is. I also discovered there are three ways in which taxpayers deal with this issue. The first group, like me, reported the exercise event and faced the tax consequences. The second group knew they should report but chose not to. Since there’s no reporting/tracking mechanism, the IRS doesn’t know there’s been a taxable event. The third group just didn’t realize they had to report. Of the three groups, I believe those who reported were in the minority. One of the fundamentals of our tax code is the fair and uniform application of the law. Clearly that did not happen here. As for reform, here are some ideas. Change the AMT formulas so this kind of injustice doesn’t happen in the future. Those of us who have credits, at a minimum, make the credit directly applicable to all future taxes owed and not just a factor in the AMT calculation as it is now. At the extreme, send us a check equal to the credit (that would be a real “rebate”; these are real dollars we’ve paid in excess of what we would have otherwise owed). And if you must hold our money, at least pay us interest at the rate the IRS charges us for late payments. It is absolutely absurd that our prepayment of taxes is a free loan to the government. Finally, if the AMT must continue, please insure it is indexed down proportionate to the regular tax rate schedule. As for the tax treatment of NQOs, stop treating the event as income at the time of grant. Taxes should be owed when income/gain is realized. That means determining taxes owed when the stock is sold. I would agree a portion could be treated as income and the change in subsequent stock price as a long/short term gain/loss. If I sound like a tax professional, I’m not. I’m one of the thousands of people granted options only to have this tax nightmare. I’ve become knowledgeable by default! I just couldn’t believe I’d owe taxes for options granted when I hadn’t received income or realized a gain. In hindsight, I would have been so much better off to have taken the pay instead of the options. I know thousands of others feel the same way (not a scenario that bodes well for business and our economy). At least I’d have the income to pay the related taxes. We need your help; fix this grave injustice! Nield Montgomery - Nevada 3rd Congressional District |