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April 29, 2005

**Proposal to Provide Fair Treatment of Incentive Stock Options under**

**the Alternative Minimum Tax**

**[Executive Summary]{.underline}**

One issue worthy of consideration by the Tax Reform Panel is the
ever-increasing reach of the individual alternative minimum tax (AMT).
Any such analysis undoubtedly would include an examination of the scope
and operation of the AMT, the historical and current policy
justifications for the AMT, and the revenue raised by the AMT. The
purposes of this submission is to highlight the need to address one
particularly egregious feature of the AMT -- the treatment in a falling
stock market of the disposition of stock acquired through the exercise
of incentive stock options (ISOs).

As explained in detail in the attached submission, ISOs are stock
options issued to broad classes of employees to encourage participation
in the growth of the issuing corporation. Present law provides favorable
regular tax rules that allow the deferral of the recognition of income
upon the exercise of an ISO. The AMT negates this favorable tax rule by
requiring taxpayers to recognize income upon the exercise of the ISOs.
However, in the case of a steady or rising stock market, the AMT
liability effectively "pre-paid" upon the exercise of the ISO is
refunded to the taxpayer when he or she disposes of his or her ISO
shares.

A discontinuity arises in the case of a declining stock markets. As
illustrated in greater detail in the submission, in such cases the
refund mechanism may not operate properly and taxpayers are subject to
significant AMT liabilities despite the absence of economic income. Real
life cases have resulted in severe economic hardship as affected
taxpayers have been forced to declare bankruptcy or sell their homes,
retirement security assets, or dependents' education funds in order to
pay this unfair tax.

A relatively easy fix can remedy this situation -- clarify that any AMT
loss on the disposition of ISO shares has the same character as any AMT
income recognized upon the exercise of the ISO. This solution results in
the taxation of economic income, prevents taxpayer whipsaw, encourages
broad employee participation in the growth of their employers, and is
consistent with fundamental concepts underlying the AMT. In addition,
this clarification would simplify compliance and reduce recordkeeping
for individual taxpayers by "closing out" all the AMT effects of an ISO
transaction upon the disposition of the stock. The solution should have
a relatively modest revenue cost and presents no opportunity for abuse
or tax avoidance.

Thank you for the opportunity to express this concern and for your
consideration of this matter. If you have any questions, please do not
hesitate to contact Joseph M. Mikrut or Jonathan Talisman of Capitol Tax
Partners, Washington, D.C., at 202-289-8700.

We are writing to request that the panel recommend modifications to the
tax treatment of incentive stock options (ISOs) under the individual
alternative minimum tax (AMT).[^1]

During the "exuberant" stock market, many taxpayers exercised their ISOs
at substantial discounts and incurred large AMT liabilities. Subsequent
downturns in the market, however, have caused those discounts to be
"ephemeral" and the gain recognized for AMT purposes to be "illusory."
Thus, upon a subsequent sale of the stock, these taxpayers typically
will have a significant negative AMT adjustment. The character of this
negative AMT adjustment presently is unclear.

We propose that the character of any negative AMT adjustment upon sale
of the ISO stock is the same as the character of any corresponding prior
positive AMT adjustment upon exercise of the ISO. This simple
clarification treatment results in the taxation of economic income,
prevents taxpayer whipsaw, and is consistent with fundamental concepts
underlying the AMT. In addition, this clarification would simplify
compliance and reduce recordkeeping for individual taxpayers by "closing
out" all the AMT effects of an ISO transaction upon the disposition of
the stock.

**[Incentive Stock Options -- Current Law]{.underline}**

Congress provided favorable tax treatment to employees who receive ISOs
in order to "provide an important incentive device for corporations to
attract new management and to retain the service of executives who might
otherwise leave."[^2] This favorable tax treatment includes no regular
tax consequences to an employee when an ISO is granted or the option is
exercised.

The favorable regular tax treatment for ISOs, however, does not apply
for AMT purposes. Under the AMT, the spread between a stock's fair
market value on the date of the ISO exercise and the exercise price
generally is a positive AMT adjustment[^3] and will result in AMT
liability for an employee in the year of an ISO exercise. The employee
will have an AMT credit (which can be used to offset regular tax
liability in future years) to the extent of such AMT liability. The
positive AMT adjustment generated in the year the ISO is exercised
reverses as a negative adjustment and is taken into account for AMT
purposes in the year the stock is sold. The AMT credit generated in the
year of the positive AMT adjustment can be used to offset regular tax
liability in a subsequent taxable year to the extent the employee's
regular tax liability for such year exceeds his or her tentative minimum
tax (which generally will be the year of the disposition of the ISO
stock because the taxpayer will have a relatively low basis in his or
her ISO shares for regular tax purposes and a negative AMT adjustment).
Thus, in the case of a steady or rising stock market, the AMT acts as a
pre-paid tax that is effectively refunded when the taxpayer disposes of
ISO shares,

The operation and interplay of the regular tax and AMT rules with
respect to ISOs can be best illustrated in the following example.

Example 1---Rising market. Assume a taxpayer was granted an ISO to
purchase 10,000 shares for \$10 each. Over a year later, the taxpayer
exercised the ISO when the fair market value of the stock was \$50 per
share. As a result of the exercise, the taxpayer had a positive AMT
adjustment of \$400,000 and a significant AMT liability. This AMT
liability provides the taxpayer with an AMT credit which could be used
to offset regular tax liability on sale of the ISO shares in a later
year.

Over a year after the date of exercise, the stock has retained its value
of \$50 a share and the taxpayer sells her shares. Because she paid \$10
for each of the shares, the taxpayer has a regular tax gain of \$400,000
on the sale. Because she has already taken this \$400,000 amount into
account for AMT purposes, she will not have any AMT gain in the year of
the sale. Rather, the taxpayer's income for regular tax purposes will
exceed her AMTI (i.e., she will have a negative AMT adjustment).
Similarly, her regular tax liability will exceed her AMT liability and
the taxpayer will to use her AMT credits to offset her regular tax
liability to the extent of such excess.

**[Potential for Whipsaw]{.underline}**

Declines in the stock market have highlighted a potential whipsaw under
the AMT for taxpayers who exercised ISOs. The following example
illustrates the problem.

Example 2---Falling market. Assume a taxpayer was granted an ISO to
purchase 10,000 shares for \$10 each. Over a year later, the taxpayer
exercised the ISO when the fair market value of the stock was \$50 per
share. As a result of the exercise, the taxpayer had a positive AMT
adjustment of \$400,000 and a significant AMT liability. This AMT
liability provides the taxpayer with an AMT credit which ostensibly
could be used to offset future regular tax liability on sale of the
shares.

Over a year after the date of exercise, the stock has declined in value
to \$10 a share. The taxpayer, seeking to avoid further investment loss,
sells her shares. Because she paid \$10 for each of the shares (and has
a \$10 basis in each share), the taxpayer does not have an economic gain
from exercising the ISO and owning the shares (and does not have a
regular tax gain on the sale). For AMT purposes, she has already
recognized \$400,000 in income in the year of the exercise which must be
reversed.

At issue is how the \$400,000 positive AMT adjustment generated in the
year of exercise in Example 2 should reverse in the year of disposition.
The employee paid AMT on \$400,000 of income in the year of the exercise
of the ISO. Such "income" was lost when the market retreated and she
sold her shares. **To make the taxpayer whole, her AMT liability should
be refunded. To accomplish this result, the law should clarify that the
character of the negative AMT adjustment is the same as the prior
positive AMT adjustment.**

**[Policy Considerations]{.underline}**

The advocated treatment of the negative ISO adjustment is consistent
with the policies underlying the individual AMT. The AMT originally was
enacted to ensure that individuals with significant economic income did
not escape taxation on such items of income. The taxpayer in Example 1
above has \$400,000 of economic income with respect to her ISO stock
over the term of the ISO transactions and is taxed on such amount. The
taxpayer in Example 2 above has no economic income with respect to her
ISO stock, but is subject to the same amount of tax as the first
taxpayer. Clarifying that the negative adjustment has the same AMT
character as the prior positive adjustment ensures that the taxpayers'
taxable incomes match their economic incomes and that both taxpayers are
treated fairly under the AMT.

Another fundamental notion underlying the AMT is the prepayment concept
with respect to timing items. The AMT negates the benefit inherent in
certain timing items by slowing down the ability of taxpayers to claim
deductions or accelerating the recognition of taxable income (as in the
case of ISOs). In order to ensure that the AMT operates as a prepaid tax
as intended with respect to ISO transactions, the negative ISO
adjustment must have the same character as the prior positive
adjustment.

Clarifying the treatment of the negative ISO adjustment will simplify
tax compliance. For many individuals, the ISO adjustments will be the
only significant AMT adjustments they will experience. Clarifying that
all the AMT effects of an ISO transaction end in the taxable year that
the ISO stock is disposed of will reduce recordkeeping and the need to
enter into transactions to ensure the utilization of AMT credits.
Finally, by only taxing economic income, the advocated position does not
create any loopholes or potential for abuse.

Thank you for your consideration of this matter.

[^1]: We understand that the AMT presents broad policy issues. We take
    no position in that debate; rather, we seek to point out one of the
    more egregious elements of the present-law AMT.

[^2]: See, S. Rep. 97-144, p. 98, (July 6, 1981).

[^3]: A taxpayer generally determines his or her alternative minimum
    taxable income (AMTI) by starting with regular taxable income and
    making adjustments. Positive adjustments increase the taxpayer's
    AMTI relative to his or her regular taxable income. Negative AMT
    adjustments decrease the taxpayer's AMTI.