Turning Paper Wealth Into Real Wealth -- Without Giving It All Away to the IRS

Incentive stock options are a fast track to the big money -- <I>if</I> you know how to play the tax angles.
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The Street is raining millionaires: For those lucky enough to be working in so-called "New Economy" firms, the chance to cash in the generous incentive stock options, or ISOs, these firms have historically provided can be the windfall of a lifetime. During August, according to Edgar Online, the insiders at some 32 newly public companies will get their first chance to exercise incentive stock options.

But should they exercise or hold? And how do taxes influence this decision?

We'll get to that, but first, let's define a few terms.

Companies can offer their employees one of two different types of stock options: incentive stock options and nonqualified options. But nowadays most of the budding tech companies are handing out ISOs.

What this means is that if you plan ahead, you can make sure you pay the lower 20% long-term capital-gains rate available to ISO holders when you sell the stock. If you don't, well, you could be smacked with a tax bill that can swallow up to 39.6% of your total gain. And that's the "incentive" (ha!) behind our discussion today.

An incentive stock option is granted to an employee to buy company stock at a contracted price sometime in the future. Think of it as a private call option between the employee and the company. ISO holders have three dates to worry about: the grant date, the exercise date and the sale date.

In order to qualify for that low capital-gains tax rate of 20%, employees must hold their incentive stock options for two years from the grant date,

and

one year from the date of exercise. And that should factor into your thinking: If you're going to need to sell an ISO in the near future, consider exercising the option as soon as the lockup expires. That way, you get the clock started. But before you do that, you've got to consider that irksome alternative minimum tax, or AMT.

Basically, AMT was created years ago to make sure that everyone -- even the super rich -- paid at least some income tax. So the

IRS

requires those with large deductions to also calculate their tax bill under AMT rules, which don't allow you any standard or personal exemptions. You also don't get a credit for any state taxes paid, nor are you allowed to take any miscellaneous itemized deductions.

But the worst part, from our lucky employee's point of view, is that you also have to add the "income" received from incentive stock options. So for AMT purposes, the difference (or spread) between the exercise price and the stock's market price on the day of exercise must also be included as taxable income.

Are you subject to AMT? First calculate your tax bill the normal way, then calculate it following the AMT rules: You must pay the higher of the two amounts. The AMT rates max out at 28% while the regular tax rates can be as high as 39.6%. But since you can't use many of your deductions and credits when calculating AMT, the lower tax rate doesn't help you much. (Check out

Form 6251

Alternative Minimum Tax - Individuals

for the skinny on the calculation.)

The Republicans want to do away with this arcane system, notes Martin Nissenbaum, national director of personal income tax planning at

Ernst & Young

. But AMT still is a big revenue raiser for Uncle Sam, so who knows.

Moi ... in the AMT?

Don't be upset if exercising some ISOs causes you to get stuck paying AMT. Although you may have a higher tax bill this year, you'll get that money back as a tax credit next year. "You're just paying your capital gains tax up front," notes Bill Fleming, director of personal financial services for

PricewaterhouseCoopers

in Hartford, Conn.

Say you exercised your stock in 1999, which generated an additional $30,000 in tax as calculated under the AMT. In 2000, you'll have a $30,000 tax credit that you can use, assuming you're not in AMT again.

Here's how you use it: Calculate your year 2000 tax bill both ways -- the normal way and the AMT way. Let's say your tax bill calculated the regular way is $100,000, and as calculated under AMT, $60,000. You can use that $30,000 credit from the year before to reduce your regular tax bill -- up to the amount of the difference between your regular tax and AMT. That'll drop your regular tax bill to $70,000.

Selling the Stock

Assuming you have waited at least one year after the exercise date and two years after the date of grant to sell your shares, you now have to pay capital gains tax on the difference between the exercise price and the sale price.

Let's say you wait the 12 months after exercise and sell the stock in 2000, and further, assume the stock hasn't moved. That means the spread you originally calculated for the AMT will now be the amount subject to capital gains tax at the time of sale.

Assuming you paid 28% AMT on the spread at exercise, you now owe only the 20% long-term capital gains tax on that same amount, so your taxes will be lower by that difference. Of course, the more likely scenario is that the stock has risen since you exercised the options, making that new spread the basis for the capital gains calculation.

The good news is that if, as in the example above, you had a $30,000 AMT credit from the year before, you can apply that credit toward this year's taxes.

The bad news is that if you didn't wait these requisite periods -- say you sold the shares in a panic -- you will have disqualified the position. That means any gain at the time of sale will be taxed at your ordinary income tax rate. And that will hurt.

Plan Ahead

Protect yourself by planning around AMT. Pull out

TurboTax

and do some number crunching. Project your tax situation out for the next few years and keep changing assumptions. What if I exercise this year? What if I don't? What if the price drops? Rises?

From a cash flow perspective, it's very efficient to exercise early in the year, says Rande Spiegelman, personal financial services manager at

KPMG

.

Here's why. Say you exercise in February 1999. You'll owe AMT in April 2000. If you wait the year from exercise and sell in, say March 2000, you'll have the sale proceeds to help you pay AMT the following April.

Year-end is not the best time to exercise because you have no time to plan your cash flow, notes Spiegelman. If you exercise in November, you'll have to come up with the money from other sources to pay the AMT in April.

Even worse, if you disqualify the position and sell before the 12 months is up, you'll owe ordinary income tax in April 2001. But because you disqualified, you won't get the AMT credit to offset that tax.

Whew.

In the end though, don't let these murky tax rules cloud your investment decisions. While you should consider your cash flow situation and the tax implications, always do what makes investing sense for you, considering both the prospects for your company's shares, and your portfolio.

Tell us about your AMT experience:

Had no idea it was my problem until I read this column.

Have dealt with it before and it made me dizzy.

Have dealt with it before and now realize it's not that big of a deal.

Hoping it all goes away before April 2000.