Alternative Minimum Tax on Incentive Stock Options
ISSUE BRIEF

Issue/Background
Incentive Stock Options (ISOs) were originally designed by Congress in 1981 to encourage employees to acquire and hold stock in their employer’s company. Employees who receive ISOs do not have to pay regular income tax on the difference between the grant price and exercise price if they hold the shares for two years after grant date and one year after exercise date. Rather they pay capital gains tax only upon sale of the shares.

After changes to the law in the Tax Reform Act of 1986, the use of ISOs saw a significant decline. First, Congress narrowed the differential between capital gains rates and regular income tax rates. Congress also introduced the Alternative Minimum Tax (AMT) for individuals. Unlike the regular income tax, the AMT applies on exercise value of ISOs rather than upon the value at the sale of the stock. Therefore, many employees must sell a portion if not all of their stock upon exercise in order to satisfy their AMT liability. By selling the stock at exercise rather than holding the stock for one year, employees must pay taxes at the higher income tax rates rather than at the capital gains rate. When this happens, there is no difference between ISOs and nonqualified options if ISOs are not held after exercise, thereby defeating the original Congressional intent behind ISOs.

Up until 1997, the effects of the small capital gains differential and AMT served to make the use of ISOs less appealing to companies and their employees. Throughout much of the 1990s few companies offered ISOs to their employees; instead, the vast majority of companies who granted options granted nonqualified stock options. However, upon enactment of the Taxpayer's Relief Act of 1997, Congress significantly reduced the top capital gains rate from 28% to 20% for assets held longer than one year. With this change, ISOs became very attractive to employers and employees again, save the outstanding AMT problem. When the market adjustment of 2000/01 arrived, regrettably the application of AMT to exercised ISOs placed many employees in an untenable tax position of having to pay alternative minimum taxes on the valuation of ISOs that the employees will not soon realize. This situation of requiring employees to pay taxes on phantom stock gains must end.

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AeA Member Impact
Enactment of AMT/ISO legislation will enable companies to retain employees with more generous benefits, encourage employee investment in the company, and enable start-up companies to be more competitive.

AeA Position
AeA is leading the effort to pass legislation that will simply repeal the application of the AMT to ISOs. As an alternative, AeA supports addressing the valuation of the ISOs for AMT purposes for exercises made in 2000. If AMT/ISO correction legislation is enacted, employers will have the choice of granting ISOs without worrying about the adverse consequences of AMT on their employees. AeA believes AMT/ISO legislation should be scored as a revenue raiser.

Status/Outlook
Several bills to address the application of the AMT on ISOs have been introduced:

• H.R. 1487 (Rep. Lofgren D-CA) amends the Internal Revenue Code to repeal the alternative minimum tax treatment of incentive stock options, thereby changing the taxable event from the exercise of the stock option to the sale of stock effective January 2000.

• S.1142 (Sen. Lieberman D-CT) the Entrepreneurs Risk Incentive Act of 2001-repeals the minimum tax preference for exclusion for incentive stock options.

• And H.R. 2794/S.1324 (Reps. Neal D-MA, Davis R-VA, Lofgren D-CA, and Weller R-IL and Sen. Lieberman D-CT) provides relief from the alternative minimum tax with respect to incentive stock options exercised during 2000, by allowing taxpayers who exercised ISOs in 2000 to chose the "exercise date" of either the date of sale of the stock or April 15, 2001, as the date for calculation of the alternative minimum tax due.

AeA supports broad AMT reform, but believes at a minimum narrow AMT reform should be passed by Congress this year. AMT/ISO legislation could be easily resolved if the Joint Committee on Taxation scores the legislation as a revenue raiser. Proposed legislation could indeed be a revenue raiser because many employers will offer ISOs instead of nonqualified option plans and forego corporate tax deductions that they currently receive with the use of nonqualified options.

AeA Staff Contact
Caroline Graves Hurley, Tax Counsel, at 202-682-4454 or Caroline_Hurley@aeanet.org

This page was last updated on 12/14/01.  
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