Stock options & the AMT

Keywords: ISO, stock options, AMT, Alternative Minimum Tax, IPO

Employees in the dot-com world were taking stock options for granted. The recent collapse of much of the market in those recent-IPO players has cooled things off a bit, but employees are no better informed now than they were before. While I'm still far from an expert, I'd like to provide some warnings that could help you avoid a worst-case scenario. Note that I'm not an expert, and that some of the numbers I use here are estimates, and there may be some other errors or omissions. As everyone says, see a tax lawyer (which I'll abbreviate as SYL). And we really mean it.

Terminology and Rules

• Non-executive employees at established public companies are typically offered a Non-Qualified Options (NQO) package. Typically the exercise price of the options is set to be the company's market price at the time of the options are issued, so the "upside" for the employee only occurs if the stock price goes up. When the employee exercises the options, the gain is immediately taxable. Then, when the employee ultimately sells the stock, another tax calculation is necessary, based on the change in price between the times of exercise and sale. Most companies offer an easy way for employees to immediately (at the time of exercising) sell enough stock to pay the first batch of taxes. Many employees take advantage of this, and hope to hold the balance of stock long enough to qualify as a long-term capital gain, which faces a lower tax rate. Most others sell all their stock at the time they exercise.
• Employees at pre-IPO companies are typically offered an Incentive Stock Option (ISO) plan. The exercise price is generally rather low (under $1/share), so if the company goes public at $10/share (the typical lowest target), that's a significant potential gain. With ISO plans, there should theoretically be no taxes triggered by exercising the options, only by selling the stock. Unless otherwise informed, employees often exercise their stock a few months before an IPO, so they can start the clock running toward a long-term capital gain, without facing a big risk of the IPO not taking place (they think).
• Employees exercising ISO options have to be concerned by the Alternative Minimum Tax (AMT). The AMT is designed sort of like a "catch the sneaky rich people" filter. (This isn't completely unreasonable, as rich people often have tricks available to cancel or at least delay taxes on increases in their wealth, especially if those increases don't get turned into actual cash.) The taxpayer does what could be considered a parallel simplified tax calculation, which recognizes certain gains that might not be included in the standard tax calculation, and drops certain standard deductions. If the difference between the AMT calculation is sufficiently different from the standard calculation, then the taxpayer pays that difference. Exercising ISO options, even if you don't sell them, is treated as a gain for AMT purposes. When you ultimately sell the stock, you should get an AMT credit against the gain, so everything should even out, but you can face a short-term cash crunch paying the tax before the sale. Employers often provide a vague warning, but most employees assume that AMT will not apply to them, so they think there are no tax consequences of exercising.
• Establishing the size of that exercise-based gain can be messy. If the company hasn't gone public at the time of the exercise, the value of the stock is estimated (since there isn't a public market value). If the company has had a funding round within the last year, they'll probably define the value as being the price set at that round, or maybe a little bit higher (or maybe a little lower, since the investors often have better terms than employees). But as the company gets close (less than a year away) to an IPO, the SEC expects the price to ramp up to the eventual IPO issue price. The value is definitely reset each time new options are issued (say, to new high-level employees, who are often hired to make a company "more respectable" as it approaches IPO). Of course, nobody knows what that ultimate IPO price is going to be, so there's a lot of guessing going on. Employers rarely inform employees before or after they re-price the company.
• There is typically a lockup period of 6 months after the IPO, where employees can't sell any of their stock (that came from exercised options). Because many companies don't sell a huge % of the company at the time of the IPO, the end of the lockup period results in a significant increase in the number of shares available to trade on the market. Standard supply/demand analysis would imply that the price will drop. A number of financial publications, online and offline, track coming lockup period endings, which has intensified the drops. Thus employees often (since early 2000) end up with much less money than they had hoped.
• Calendar-year changes can become significant. If the IPO occurs in the Fall of a given year, then the employee can't sell any of his stock until the lockup period ends in the following Spring. Therefore he will be forced to find another way to pay his AMT tax. Even if the stock price has fallen by the time he sells, even if the price has fallen by the end of the year when he still can't sell, the AMT will be based on the value from the time of the exercise. (If he ends up selling at a dropped price, then he should get a credit that later year [12/13/00 addendum: it may take years to get the credit, there appears to be a $3k/yr credit limit! [3/28/01 addendum: it turns out I am getting almost all my credit back in the first year. My accountant checked with an attorney, but just took a verbal interpretation to save on the legal fees, so I don't know why it worked out OK for me, or conversely why it might not under other conditions]]. But that doesn't help with the short-term cash crunch to pay the original tax.)

A hideous example

Here's what happened to many employees at my ex-employer:

• They were early-stage employees, so they had stock options that had been issued at much less than $1/share.
• They exercised their options in the last few months before the IPO was scheduled. Unfortunately, because nobody in management gave them a heads-up as to when the estimate share values would be marked up, the market value at that time was $10/share.
• The IPO was delayed a couple months (the pre-crash in late-summer 1999), then was completed in the fall at $7/share.
• But of course employees couldn't sell for 6 months, which was in spring 2000.
• While management had distributed some legalese noting that "there may be AMT consequences" of exercising stock options, few people realized that the tax bite would be roughly 25% x $10 x #shares! On top of that, if they were going to exercise another block of options in 2000, they'd need to be laying out lots of money in quarterly estimated tax payments as well!
• The company eventually let people rescind the exercising of their options, so they could do it later [Feb01 update: see IndustryStandard article noting this practice]. Other people (like me) kept the options and borrowed money from relatives to pay their taxes (since that 6-month lockup didn't end until right before taxes would be due). [Because I left early in the first quarter of 2000, I was forced to exercise (or lose) another batch of options, and had to borrow additional money to pay a first-quarter Estimated Tax bill, since I was hoping to hold the stock for a full year to get the long-term capital gains tax rate, meaning I might face another AMT hit for 2000, payable in 2001).
• Then, the stock price lost about 80% of its value in the few weeks before that lockup period ended, making that $10/share tax basis even more galling.
• Ultimately, as the market stayed weak (for dot-coms in general, and my ex-employer in particular), I decided to sell 100% of my shares in 2000 to "wash out" the AMT calculation. I know someone in a similar situation who's planning on selling some shares and then buying them back again (there may be some rules as to how much time must pass between those two transactions).

Events that could affect the timing of actions you take:

Reviews, raises, promotions, etc.: consider whether you'd like more of your reward in options or cash. You often can't control this, but it never hurts to ask.

Company funding rounds: if the company's about to close a new round of funding, and you think you might be worth a bonus (in options), ask someone about making that happen before the funding closes, so those options can be issued at a lower exercise price.

End of year: decide whether to exercise some options. With post-IPO stock options, the most common form of behavior is to exercise your options on the day you want to sell the stock. A smaller number of people plan on waiting a year between exercise and sale to get the lower long-term capital gains rate. With early-stage options, you probably have a much larger gain involved, so there's more reason to consider exercising a year before you intend to sell. And the AMT gives you an even better reason, since you'd like to minimize that initial tax bite by exercising when the price is low. So, the bottom line is that if you have a big chunk of options vested, and the company's current estimated value is still pretty low, then you minimize your AMT by exercising now rather than later. Offsetting this, of course, are two considerations: (a) the time-value of that money you have to pay your company to exercise the options (plus the AMT tax bill), which doesn't return a profit until you sell the stock years later; and (b) the possibility that the company will never go public at all but will sink into oblivion, leaving you holding valueless stock. You should be able to take the exercise price as a capital loss, and you should be able to get a full refund of that AMT bill (though I can't swear to this, SYL).

When the company gets close to IPO time: as noted above, this is when the estimated value of the company can ramp up quickly every month. So exercise early if you plan to at all. Once the price starts ramping up, you might want to wait until after the lockup period ends.

Right when the company goes public: this is probably the worst time to exercise (for AMT calculation reasons), as the stock is mostly likely to be irrationally inflated.

When the post-IPO lockup period ends: many Internet companies take a nose-dive (at least in stock price) just at the time of the lockup ending, because investors get worried about employees dumping their shares. Certainly the liquid supply of shares increases at that time, so this isn't unreasonable. But that means that you might want to wait a little while to exercise.

When you're thinking about quitting: might your company be getting acquired? If so, and your options grant has the change-in-control clause I noted above, then it might be worth your while to stick around awhile. Unfortunately, few employees know about these things in advance. It's not like anyone's taking the time to think them through! If you're not in an immediate rush to quit, you might also want to consider other factors noted here: for instance, if you want to delay the AMT bite for awhile, then sticking around long enough to delay your final exercise into the next calendar year might make sense. And of course, if you have a big annual vesting period approaching you want to wait for that.

When you quit: you'll have to exercise your options, usually within 30 days of quitting. If the company hasn't gone public yet, you have to decide what the odds are of that happening (at a profitable price): you could end up holding restricted shares in a private company that never goes public.

created Nov21'00