| Individuals holding incentive stock options have historically faced a dilemma at tax time. If options are in the money, they may be subject to the alternative minimum tax (AMT) on paper profits even before selling their shares. If they sell their shares at a loss, their net capital loss deduction is limited. It helped that the AMT liability gave them a credit on subsequent years’ regular tax and that the credit could be carried forward. But even so, many people had far more credit than they were able to use. This situation became especially prevalent among individuals who were granted options during the boom years of the 1990s. Congress came to their rescue with a little-noticed provision within the Tax Relief and Health Care Act, signed in the final days of 2006. For 2007 through 2012, taxpayers with such AMT credit carryovers that are more than three years old can claim a refundable credit equal to the greater of $5,000 or 20% of the unused minimum tax credit. Exercising an incentive stock option (ISO) is usually tax-free to individuals for regular tax purposes as long as the stock is not disposed of within one year from date of exercise or two years from date of grant (IRC section 422). However, the spread between the exercise price and the market price (the paper profit) is subject to the AMT and is included in alternative minimum taxable income (AMTI) as an adjustment. Certain AMT adjustments, referred to as “timing or deferral” adjustments, including ISO exercises and depreciation, generate AMT credits. The credits can offset regular tax in years in which the regular tax bill is higher than the AMT and can be carried forward indefinitely. The income recognition for AMT purposes for the exercise will cause the underlying stock to have an AMT basis different from the regular tax basis. When the stock is later sold, capital gain for AMTI purposes will differ from that of regular tax. If the stock is sold for less than the amount paid, the loss may not be allowed in full, due to the $3,000 limit on deductibility for net capital losses. As a result of these rules and the required income recognition, many individuals have large AMT credit carryovers related to stock in which the fair market value has dropped well below the income previously recognized for AMTI purposes. For 2007, the credit must have been generated in 2003 or earlier. The unused minimum tax credit eligible for refund in 2007 can be determined by referring to line 26 of the 2003 form 8801 and adjusting the carryforward for any amounts claimed in 2004, 2005 and 2006.
| If the unused minimum credit carryforward is: | Then the AMT refundable credit amount is: | | Less than $5,000 | The unused credit carryforward amount | | At least $5,000, but not more than $25,000 | $5,000 | | More than $25,000 | 20% of the credit carryforward |
Complicated phase-out rules apply to higher-income earners. For 2007, couples filing jointly will lose 2% of the AMT credit refund for each $2,500 by which their adjusted gross income (AGI) exceeds a threshold amount.
Here’s an example of how the credit can work: In 2007, a taxpayer has an AMT credit carryover of $200,000 from 2003 or earlier. (His 2007 income is below the AGI phase-out threshold.) His credit refund would be $40,000. If his current-year tax liability is $10,000, the refund would wipe out the liability and he would receive a check for $30,000. In 2008, the credit carryover will be reduced to $160,000 ($200,000 less the previous year’s $40,000 utilization.) The taxpayer may be eligible for a $32,000 refund ($160,000 x 20%), depending on his 2008 AGI. Starting in 2007, taxpayers use form 8801 to compute the refundable portion of the credits. This new law provides many planning opportunities for use of the credit and for the future exercise of options. For example, the potential refunds should be considered when planning estimated tax payments for 2007 and forward. In addition, the refunds should be computed when extending 2007 returns. Since this provision is available until 2012, future refunds can be projected for planned exercise transactions, allowing practitioners to advise their clients on the tax effect of options exercised and the ultimate refund available. By Diane Giordano, CPA, CFP, senior tax manager of Marcum & Kliegman LLP, Melville, N.Y. Her e-mail address is DGiordano@mkllp.com. |
