John M. Hoffman & Associates CPAs
Frequently Asked Tax Questions
Now lets take a look at what can happen from here; now 4 alternatives:
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For whatever reason you can not wait out the next 12 months and you sell your stock. By doing so, you have created a disqualifying disposition. This means that you can forget about the AMT and the whole profit on the deal is treated as ordinary income. In fact, you are supposed to tell your employer so they can report it as taxable wages. There are times when you might want to do this, such as the stock heading downwards and you wanting to bail out. Please note the distinct advantage of starting this one year transaction at the first day of a calendar year so that you have almost the entire 12 month holding period window falling within the same tax year – I know this is complex but if you dump the stock within 12 months but that dumping date falls into a subsequent year you still owe the AMT in the previous year – OUCH!
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You wait out the 12 months and on January 2, 2007 the public offering for CC at $20 occurs. As to these 20,000 shares acquired one year and one day ago, you can sell the shares on January 2, 2007 and at that $20 price you collect $400,000. For regular tax purposes you have a long term capital gain of $360,000 taxed at 15%, or $54,000. For AMT, your capital gain is $340,000 because your basis for AMT purposes was increased from the $40,000 you wrote the check for by the $20,000 of tax preference that you had. All things being equal, your AMT is less than your regular tax and the AMT that you paid for the year when you exercised the options (bought the stock) is refunded (in theory).
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Despite everything looking wonderful, and your patience, on January 2, 2007, the company gets bad news that the drug failed clinical tests and the company closes its doors. Not only are all those other stock options worthless, but the 20,000 shares that you paid $2 per share for worthless. For income tax purposes you have a $40,000 capital loss that you get to deduct $3,000 per year for the next 13 and 1/3 years. For AMT purposes you have a $60,000 capital loss that is deducted in the AMT calculation at a rate of $3,000 per year so that loss will last you 20 years. Despite having paid the AMT on the paper profit, you essentially will not get that back until years 14 through 20 when your AMT is less than your regular tax because you get that additional $3,000 of capital loss per year from years 14 through 16. In case you have not surmised – THIS is what you DO NOT want to let happen. Don’t forget that you still need to write that check for the $5,600 of AMT on April 15, 2007. This is particularly painful since the $40,000 you paid for the stock has gone down the drain, and now you have to pay tax on paper profits that evaporated (and from what source do you get the money to pay this tax)?
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And this we think is the most likely event. On January 2, 2007 as an additional 20,000 of your original grant of options vest, and the first 10,000 of your 2nd grant vest, everything is smooth sailing. The company is continuing to make good progress and they just announced that the stock value has gone to $6 and you have been granted 30,000 additional ISOs with a strike price of $10, vesting 20% per year going forward. There is no current market for the shares but you are confident that an IPO is just around the corner. Accordingly, you decide to exercise another 20,000 of the original options, writing the company a check for $40,000 and including $80,000 of AMT preference. This could cost $28,000 in AMT the following April. I think you can see that the money is getting real serious here.
Still within alternative 4, let’s take a look at how this breaks down financially.
