Tax Bill Provides AMT Relief for Incentive Stock Option Holders

The 2006 tax bill recently passed by Congress contains a provision allowing individuals who paid the alternative minimum tax (AMT) on the exercise of stock options to take a tax credit of 20% (or, if the original credit is less than $25,000, $5,000 or the full amount of the credit, whichever is less) against ordinary income, not just capital gains losses. The 20%, however, applies to the remaining balance, not the original balance, so over five years, only about two-thirds of the amount could be reclaimed (at most). The credits can be taken through 2013. The credit phases out for incomes generally above $150,000 (single filers) or $218,000 (married filers), but the rules are very complicated. AMT amounts from three years before the current tax year are eligible, so for the 2006 tax year, the rule applies to AMT amounts in 2003 and earlier.

Incentive stock options are a preference item under the AMT, meaning that the spread on options exercised in a tax year has to be added back to calculate the AMT. If the AMT amount is larger than the ordinary tax calculation, the taxpayer pays the AMT. The difference can be credited against future tax payments when the regular calculation exceeds the AMT calculation, but losses on stock can only be offset against capital gains losses or against ordinary income at no more than $3,000 per year. That caused a problem for people who exercised an incentive option in one year and chose to hold on for at least 12 months to get more favorable capital gains tax treatment. They often had to pay the AMT on the spread at exercise. If the stock price then dropped before the sale, they could end up with phantom income. They got a credit, but they might not ever be able to use it fully. The new provision makes it possible to offset the income against ordinary income tax, making it more likely to be usable. What is more, the new provision's credit is refundable, so the amount (if any) of the credit that exceeds tax payments can be claimed as a refund.

Critics say that people knowingly took a risk in following this strategy and could have sold off some shares in the year of exercise to pay the taxes. It is unclear how many people will be able to benefit from the provision. We estimate it could be some tens of thousands, however.