OT (options):
There are two types of options, Incentive Stock Options (ISOs) and Non-Qualifying Options (NQs). These two types of options get very different tax treatment. ISOs can be exercised to purchase the underlying security without incurring an immediate tax on the difference between the market value and the strike price, while with NQs this difference is taxed immediately as ordinary income. The tax treatment from the employer's perspective is almost the inverse - when ISOs are exercised they have no tax effect, but when NQs are exercised the employee's gain is deductible by the company as a wage expense.
In the old days, companies mostly gave out ISOs, until the temptation of the differential tax treatment caused most of them to switch to NQs. With NQs, the company can take a big tax deduction for "paying" an employee even though they haven't actually put out any cash! Employees, of course, are losing the favourable tax treatment of the ISOs. This is because an employee exercising an ISO can hold the security for a year and convert the entire gain into a long-term capital gain, taxed at the lower 20% rate (half of the roughly 40% they would otherwise likely be paying).
It gets a bit more complicated than this because of the infamous Alternative Minimum Tax (AMT). This odious class-warfare measure, enacted by a Democratic congress and signed by President "read my lips", got loads worse in 93 when Mr. Clinton hiked the top rate. It's especially bad for people who live in high-tax states like California, because state taxes are treated as a preference item by the rules of the AMT and thus aren't deductible. Anyway, the ISO option "gain" is taxable under the rules of the AMT, so the net effect is to force employees exercising ISOs to pay a tax on a paper gain that they haven't yet realised as cash money. In theory, they can recapture this "pre-paid" tax in later years because the AMT tax can be negative versus your normal income and provide you an opportunity to deduct AMT payments rolled over from previous years.
The bottom line for employees with ISOs is that there's a strong temptation to exercise the stock options and hold the underlying stock for a year. They have to lay out cash to exercise, plus they have to lay out cash to pay the AMT. But, in theory, they will pay a lower tax rate in the end, and recapture the AMT in the out years. The main risk should be obvious: if the stock plunges during the holding period, your cap gain will be much lower but you'll already have paid the AMT. A lot of people in this situation this year probably dumped their shares over the past few weeks so that instead of paying AMT on what might have been a large-looking gain early in the year, they will simply pay tax on ordinary income on the entire actual gain (which is now a lower number). Thus, the rumours of AMT-related tax selling adding fuel to the fire of ordinary tax-loss selling. It gets worse if you lacked the cash for the initial outlay and decided to borrow it against the stock. This seems to be what happened to some of these unfortunate softees. |
