ISOs and AMT: improving the odds when gambling with the IRS.

• Author: Takacs, Natalie Bell
• Position: Incentive stock options, alternative minimum tax

In a well-known song, "The Gambler," Kenny Rogers advises, "[k]now when to hold 'em, know when to fold 'em, know when to walk away, and know when to run." Although intended for card players, this advice should also be heeded by holders of incentive stock options (ISOs). ISOs can be a huge trap, because they appear to offer a wager that seems too good to pass up--the opportunity to convert ordinary income (generally taxed at 35%) into long-term capital gain (generally taxed at 15%).With an apparent 20% payoff, the wager seems enticing.

Under current law, however, the casino (i.e., the IRS) has two big advantages: (1) under Sec. 422, taxpayers must hold the shares for one year after exercise (or, if later, two years from the date the option was granted); and (2) under Secs. 55 (b)(2), 56(b)(3) and 83(a), for alternative minimum tax (AMT) purposes, the "spread" (i.e., the difference between the amount paid to exercise the ISO and the stock's fair market value (FMV)) is taxable at ordinary income rates in the year in which the option is exercised. Thus, almost all taxpayers who exercise ISOs will be subject to the AMT. Why is that a problem? After all, AMT is just a timing difference (i.e., a prepayment of tax that will be credited back to the taxpayer when he or she later sells the stock that gave rise to the AMT in the first place), right? Not necessarily. In many instances, ISO taxpayers are unable to recover the full AMT credit, especially when the price of the stock later declines.

Facts

Consider, for example, the case of Robert J. Merlo. During 1999 and 2000, he was employed by Service Metrics, Inc. (SMI). On July 2, 1999, he was named its vice president of marketing. On July 14, 1999, SMI granted him options to purchase 275,000 shares of its common stock with an exercise price of 10 cents per share. The options qualified as ISOs under Sec. 422. On Nov. 23, 1999, Exodus Communications, Inc. (Exodus) acquired SMI and converted Merlo's options to purchase SMI common stock into options to purchase Exodus common stock.

Insider trading: Exodus had an insider trading policy that provided, in pertinent part:

It is illegal for any Director, officer or employee of Exodus Communications, Inc. (the "Company"), to trade in the securities of the Company while in the possession of material nonpublic information about the Company ... Violation of this policy or federal or state insider trading or tipping laws by any Director, officer or employee may subject a Director to dismissal proceedings and an officer or employee to disciplinary action by [Exodus] up to and including termination for cause" (Emphasis in original.)

The insider trading policy did not require Exodus stock to be returned if a shareholder attempted to sell his or her stock in violation of the policy.

ISO exercise: On Dec. 21, 2000, Merlo exercised ISOs to purchase 46,125 shares of Exodus common stock at 20 cents per share, for a total exercise price of $9,225. The price of the optioned stock on the National Association of Securities Dealers Automated Quotation System (NASDAQ) on Dec. 21, 2000, was $23.3125 per share, for a total $1,075,289 FMV on the exercise date. Exodus filed for bankruptcy on Sept. 26, 2001, rendering Merlo's shares worthless.

On his 2000 Federal income tax return, the taxpayer did not use the stock's FMV on the...