Congress passed legislation to create incentive stock options (ISOs) in 1981 to provide entrepreneurial companies that must conserve cash a way to attract and retain top talent with an alternative form of compensation.
ISOs give employees a stake in the company’s success, providing a non-cash incentive to work hard and build long-term value.
Congress provided two significant incentives to encourage employees to invest in and work for the long-term growth of their companies:
- Employees are not required to pay tax on the “spread” between exercise price and current fair market value when the ISOs are exercised.
- Employees enjoy capital gains treatment on any long-term gain when the stock is sold.
The Alternative Minimum Tax (AMT), however, nullifies these incentives by imposing a prepayment tax on the spread at the time the options are purchased, without beneficial capital gains treatment. Although the prepayment generates an AMT credit intended to offset roughly the same amount of tax that will be imposed under the regular tax law upon sale of the stock, an unintended flaw in the AMT law renders the credit nearly useless when the stock’s value plummets or becomes worthless.
Taxed on Phantom Income
When the stock market crashed earlier this decade, tens of thousands of employees and entrepreneurs in small and large companies across America were forced to pay tax on stock income they did not receive, resulting in a tax burden that bore no relationship to actual income.
Many faced AMT burdens that were three and four times their entire actual annual income.
For many, the consequences have been devastating and life-altering. Families have been forced to liquidate assets, take out a second mortgage on their home, or have their wages garnished to pay an AMT initially designed as a temporary prepayment for future expected stock sale income.
In addition, the unintended permanency of the AMT prepayments has tied up capital that would otherwise be invested in starting new companies and growing current businesses. The AMT application to ISO compensation has created a disincentive, rather than the intended incentive, to engage in entrepreneurial activities.
— Tim Carlson and Brian Trauman