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Stock Options Add Tax Wrinkle for Many ‘Dot-Com’ Employees

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The “dot-com” shakeout is claiming a new wave of victims: workers who face huge tax bills on phantom profits from employee stock options.

Employees who used incentive options to buy company stock earlier this year and then held onto their shares have often seen their paper gains evaporate as high-tech issues tumbled. But thanks to the way the options are taxed, these workers often must pay tax based on their original paper profit--whether or not they saw the money.

In some cases the tax bill is so big, and the stock now worth so little, that families are scrambling for ways to meet their obligations to Uncle Sam, tax preparers say. There is one possible avenue of escape, but the workers have to act before the end of the year.

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One local dot-com executive, for example, used incentive stock options to buy more than 240,000 shares of his company’s stock at 14 cents a share Jan. 12. The stock closed at $19.75 that day, meaning he paid about $33,700 for $4.7 million worth of stock.

Today, however, the stock is trading for around 19 cents and the shares are now worth $45,600. But he faces a tax bill of more than $1 million, based on the value of the shares the day he bought them.

This executive is just one of hundreds of executives--many from formerly high-flying tech companies--who potentially face big tax bills on ephemeral options-related gains, said Robert Gabele, director of insider research for Boston-based First Call/Thomson Financial, which tracks stock purchases and sales by company insiders.

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The problem isn’t limited to executives. As more companies grant options to rank-and-file workers, accountants say they are increasingly counseling middle-income employees who face large and often unexpected tax bills.

“A lot of people who are working for high-tech companies are making very little money--$30,000, $40,000 a year--and they have this big tax problem” thanks to options, said Robert Munger, a Silicon Valley certified public accountant who specializes in stock option issues.

The loss of stock wealth has been dispiriting for those who accepted options in lieu of higher salaries in hopes of reaping huge gains when the stock price soared. Those dreams, especially prevalent at tech companies, evaporated as the Nasdaq composite index plunged more than 50% from its March all-time high.

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But the tax reality comes as a particular shock to those who thought incentive stock options couldn’t be taxed when used to buy shares. This misunderstanding is widespread, tax preparers said.

“I’ve even heard of companies telling their employees that an [incentive stock option] isn’t taxable,” said Roberta Schmalz, a Cupertino, Calif., certified public accountant who frequently lectures at accounting conferences about stock options issues.

It’s true that incentive stock options don’t incur regular income taxes when they are “exercised”--or used to buy company stock. That’s in contrast to the other type of stock option, non-qualified options, which generate taxable income on the day they are exercised.

Shares bought with incentive options also can qualify for favorable capital gains treatment if held for more than a year, which is why many people choose not to sell their shares right away.

But using incentive options can subject the employee to a different kind of tax--the alternative minimum tax. The so-called AMT is a parallel tax system with just two tax brackets--26% and 28%--and far fewer deductions than the regular income tax system.

Congress designed the AMT to make sure wealthy people can’t use deductions, credits and loopholes to escape taxes altogether. But the AMT isn’t indexed for inflation, so an increasing number of Americans have become subject to the tax in recent years. The Treasury Department estimates at least 1.3 million taxpayers will owe the tax this year, compared with 618,072 in 1997.

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The operative phrase is “at least.” The Treasury Department based its estimate on 1995 tax data, when incentive stock options were less common, said Treasury spokesman Steve Posner. The actual number paying the alternative minimum tax is expected to be even higher because of the growing popularity of incentive stock options, he said.

Whether a taxpayer is subject to the AMT depends on a variety of factors, including the amount of deductions taken relative to his or her income. But large paper profits from exercising incentive stock options often are enough to subject people to the tax, preparers say.

When incentive options are used to buy stock, the difference between the price an employee pays for a stock and its fair market value on the date of purchase--in other words, the paper profit on the day the option is exercised--is added to the taxpayer’s income under AMT rules.

If the total tax owed under AMT is more than a taxpayer would owe under the regular tax system, the taxpayer must pay the larger amount.

Employees who bought stock using incentive options often have a way out--they can sell the stock before the end of the year. Such a sale essentially disqualifies the shares from incentive stock option tax treatment, so that the employee only has to pay ordinary income tax on the difference between the price paid for the stock and the price received when it’s sold.

Not all employees can sell, however. Some face formal restrictions that prevent them from bailing out. Others, particularly executives, are under heavy pressure from company management not to sell, because insider sales can be interpreted by investors as a sign of dimming company prospects, tax preparers say.

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Some employees are reluctant to sell, because they believe their stock will rebound and they don’t want to lose the preferential long-term capital gains tax treatment that stock purchased with incentive options can bring. To pay the tax, they will need to dip into their savings, borrow the money or try to arrange an installment plan with the IRS to pay the bill over time.

Still others--particularly rank-and-file workers, who are less likely than executives to have tax professionals to advise them--may not even realize they have a problem until it’s too late.

“People read that these stock options aren’t taxed [under regular tax rules], but they may not get the rest of the story [about AMT],” said Karen Goodfriend, a Palo Alto CPA. “With people who don’t have a tax advisor, there’s always the chance that they’re totally unaware of the tax.”

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Liz Pulliam Weston is a personal finance writer for The Times and a graduate of the personal financial planning certificate program at UC Irvine. Questions can be sent to her at liz.pulliam@latimes.com or mailed to her in care of Money Talk, Business Section, Los Angeles Times, 202 W. 1st St., Los Angeles, CA 90012. For past Money Talk questions and answers, visit The Times’ Web site at https://www.latimes.com/moneytalk.

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Option Grants

The number of American workers eligible to receive stock options increased dramatically during the 1990s. Number in millions:

Note: Figures include incentive and nonqualified stock options.

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Source: National Center for Employee Ownership

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