Taxing stock options

Shareholders shocked by enormous bills for paper profits; advocates want reform

By May Wong
ASSOCIATED PRESS

April 14, 2001

SAN JOSE -- Like so many others in the high-tech world, Jeffrey Chou watched his millionaire dreams crumble along with the plunging stock market last year. But through it all, the 32-year-old hardware engineer never expected he would have to endure a taxpayer nightmare for the rest of his life.

Chou owes the Internal Revenue Service taxes on $6.5 million in paper profits he never saw after exercising Cisco Systems Corp. stock options last year.

By Monday's filing deadline, the married father of an 8-month-old daughter would have to come up with about $2.5 million to pay his state and federal taxes. Even if he were to sell his three-bedroom townhome, cash in his 401(k) account, liquidate all his assets and hand it over to the IRS, he figures he'd still fall $700,000 short.

"There's no chance I can pay the government back within my lifetime," said Chou, who left Cisco for a job at a Silicon Valley start-up in January. "I'm not an executive. I'm just a regular engineer, and now I face potential bankruptcy."

Thousands of taxpayers are in similar binds after losing at roulette that many employee stockholders play with capital gains rules. But many tax specialists also blame the growing problem on the decades-old alternative minimum tax.

Created in 1969, the AMT was designed to ensure that the wealthy would have to pay some amount even if they were using many tax shelters.

Today, the notoriously complicated AMT is increasingly snaring middle-income taxpayers and stock-options holders, forcing them to pay higher taxes. Also required is an additional, 62-line tax form -- a chore the IRS estimates takes more than five hours to complete.

"The AMT has gotten completely out of hand because it's not capturing the people it was intended to capture," said Bill Gale, a senior fellow at The Brookings Institution.

As average investors jumped into the soaring stock market and more companies made stock options an essential part of compensation packages, tax law didn't keep up with the changes, Gale said.

Matt Plummer, a 22-year-old employee at San Diego's MP3.com, had to consult with an accountant for the first time last year to figure out how to handle the AMT on his stock options.

Plummer had exercised his stock options in February of last year, when MP3.com's share price was about $25. He watched the stock drop to about $4 in November and was faced with a dilemma.

One option was to hold on to the shares in the hopes that the price would go up, but that would mean paying hundreds of thousands of dollars in AMT. Another choice was to avoid the AMT by selling the shares.

Plummer decided to sell about 85 percent of the stock he had exercised.

"I was basically forced to sell before I really wanted to, and that was so I wouldn't pay some ridiculous amount of money that I didn't have," he said.

He's still going to pay taxes in the high five-figure range, however, on the income he earned from selling the stock.

From now on, Plummer said, he's selling his shares as soon as he exercises the stock options.

"I'm not going to let the market burn me," he said. "I will never exercise stock without selling it right away."

Three years ago, 600,000 taxpayers were subject to the minimum tax. In 2001, that number is expected to hit 1.5 million. If current law remains the same, more than 17 million taxpayers will be pushed into the AMT sector by 2010, according to the Treasury Department.

Under President Bush's tax-cut proposal, the number of those affected by the AMT could be 35 million in 2010, according to Congress' Joint Committee on Taxation.

The National Taxpayers Advocate, a division of the IRS, has strongly recommended a repeal of the AMT since 1999.

"It's a tremendous burden," said W. Val Oveson, the former National Taxpayer Advocate and now a managing director at PricewaterhouseCoopers. "It's so complicated, general tax practitioners sometimes miss it."

More than a dozen Democrats in the U.S. House are co-sponsoring a bill introduced last week that would provide an AMT exemption for workers who exercise incentive stock options, retroactive to last year. Rather than taxing paper gains, any taxes would come on actual gains after a stock is sold.

Part of the reason more taxpayers are facing the minimum tax is that, while regular tax liabilities were pared over the years or adjusted for inflation, the AMT was not. The minimum tax rules also limit personal exemptions, including child credits and deductions such as state taxes.

Chou was pushed into paying the AMT because it applies to incentive stock options granted to employees and is based on the paper gains made on the day the options are exercised, even if the stock value later drops.

The number of employees receiving stock options ballooned to an estimated 10 million in 2000, up from 1 million in 1992, according to the National Center for Employee Ownership.

"Stock options used to be for the highest paid in the corporations, the president and the VPs, but what happened in the dot-com era is stock options came down to the masses," said Bob Sommers, a San Francisco tax attorney.

Tax specialists say those who exercised their stock before the Nasdaq meltdown last spring could have sold the stock before year-end to avoid the AMT, or at least cut their losses by paying taxes on the actual capital gains.

Many of Rich Dunham's clients did that, but the San Jose certified public accountant said others chose not to sell, gambling that their stock was immune to further declines. Now about 10 of his firm's 1,300 tax clients "are in real trouble and cannot pay," he said.

Still others were probably following what they were advised to do, said Kaye Thomas, a stock-options expert and author of "Consider Your Options."

"For a lot of people who get stock options, all they hear is that if you exercise the option, you hold it for a year to get the best results," he said.

Still others couldn't sell even if they wanted to because they were in a "lock-up" period, intended to curb trading abuses by insiders.

Consider Sheryl Johnson, a 33-year-old marketing manager for Turnstone Systems Inc., an equipment supplier for providers of digital subscriber lines.

Johnson exercised her options before Turnstone went public in February 2000, then watched helplessly as the DSL market went south at the end of the year, dragging her company's stock price from $107 to its current $7 range.

Now she says she owes the IRS $250,000, and her dreams of building a nest egg and buying a home are gone. "I don't have $250,000 lying around," she said.

She says she debates every day whether to sell all her stocks, which would be enough to pay the tax bill, or hope for a stock rebound, file a tax extension and face extra penalties.

"The closer we get to April 16, the more I think about it," she said. "It gives me a headache every time."

Staff writer Kim Peterson contributed to this report.