Every Wednesday I read
The Wall Street Journal's
Page One Tax Report.
Thanks to the convoluted tax laws, good tax advice is hard to come by. Because the
reports sound information, I imagine I'm not the only one who checks it out. However, there was a bit of misleading information contained in the Nov. 29 Tax Report that needs to be clarified.
Here's the gist: If you exercised incentive stock options earlier this year, you may consider selling those shares before year-end to avoid paying the dreaded alternative minimum tax, or AMT. The
reported that if you still believe in the stock, you then can buy the shares back the next day at their new low price and still be in the position.
True. But it failed to mention that when you repurchase those shares within 30 days of the sale, you enter wash sale territory.
The oversight gets to the heart of the murky tax laws involving incentive stock options, AMT and wash sales. Let's walk through this mess together.
incentive stock options
, or ISOs, all appreciation over the exercise price is taxed at the capital-gains rates when you sell, assuming you hold the shares at least two years after the options are issued or one year after exercise, whichever is longer. But that's assuming you are not a casualty of the
alternative minimum tax. And these days, too many people are.
"If you make between $90,000 and $300,000, AMT is just lurking. It's breathing down your neck," says Bill Fleming, director of personal financial services for
in Hartford, Conn.
As a recap, AMT was created years ago to make sure that everyone -- even the super-rich -- paid at least some income tax. The
Internal Revenue Service
requires those with large deductions also to calculate their tax bill under AMT rules, which don't allow 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.
The worst part is that an ISO's spread -- the difference between the exercise price and the stock's market price on the day of exercise -- also must be included as taxable income for AMT.
So if you're not in AMT, you don't pay a thing until you sell. If you are in AMT, you owe tax at exercise.
But how do you know if you're subject to AMT? You have to run the numbers. Get out
or your favorite tax preparation software and prepare your tax return with an exercise of ISOs and without. The software will let you know if your exercise bumps you into AMT (odds are good it will). Check out
-- Alternative Minimum Tax - Individuals
-- for more details on the calculation.
Let's walk through an example. Earlier this year, you exercised ISOs and owe AMT as a result. Your options had an exercise price of $6. The stock was trading at $29 on the day of exercise, so for AMT purposes, you will be taxed on $23.
But now the stock has tanked. You have a fat tax bill on your hands and you don't even have a rising stock to thank for it. Double whammy.
Unfortunately, the best thing you can do is to "disqualify" the position. That's accountant-speak for selling the stock before the calendar year is up. Remember, you're supposed to hold the shares at least two years after your options were issued and one year after you exercised, to guarantee yourself the 20% long-term capital gains rate on any appreciation. But if you wait that long, you may not have any appreciation left, at the rate your stock is sinking.
By "disqualifying," you no longer qualify for the long-term capital gains rates. Instead, you will owe ordinary income tax on the difference between your exercise price and the fair market of the stock on the day of the sale. The good news is you avoid paying AMT.
In our example, we'll assume you decide to disqualify and sell the shares at $13 before the year is over to salvage some gain. You will owe ordinary income tax on $7 now and will not owe AMT on $23.
But what if you'd like to steer clear of AMT and still believe in the stock? The
column said that you could buy the shares back immediately at their lower price.
That's true -- but repurchasing those shares comes with big consequences that were not mentioned.
There is a bizarre little-known provision in the tax code that says if you disqualify your ISO stock and then buy those shares back within 30 days, the wash sale rule will kick in, says Martin Nissenbaum, director of income tax planning at
Ernst & Young
wash-sale rule says that if you sell a security at a loss, you must wait at least 30 days before you can buy back that same security, or the tax loss will be disallowed.
But wait! There's no loss, in our example. You have a measly gain of $7. True. But the rule also says you must ask this question: If there were a loss, would it be disallowed? In our example, the answer is yes, because you repurchased the shares within 30 days of the sale. Now the whole transaction becomes tainted.
You no longer owe ordinary income tax on the $7 gain. Instead, you will owe ordinary income tax on the original $23 spread.
It doesn't make a difference that there isn't a loss. By repurchasing the shares back within 30 days, you blew it, says Fleming.
It's not all bad. As with all wash sale transactions, the unused $13 can be added to the basis of the repurchased stock, says Nissenbaum. See this previous
column for more on using your disallowed loss.
One last bit of bad news. If you received a new grant of options within 30 days of disqualifying your ISOs, you get stuck in this same mess.
The moral here is if you disqualify your ISO shares to avoid AMT before the year is over, don't attempt to buy the shares back within 30 days.
Everyone should know by now that Uncle Sam will never let you have your holiday cake and eat it, too.
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