Valley Forge, PA

The dilemma that taxpayers find themselves in when they dispose of corporate stock at a loss after recognizing significant amounts of income for alternative minimum tax (AMT) purposes is nothing new. This issue has been discussed and analyzed and fought over for the last several years. However, even though taxpayers' arguments are being rejected and the government is winning, the battle is still being fought. There were several cases decided in 2006 and 2007 and it is important for anyone giving advice to taxpayers in this situation to look at the arguments and holdings in the cases.

Under §421(a), an employee is allowed to defer regular tax on income resulting from an incentive stock option (ISO) until the employee sells the stock. Upon sale of the stock, the employee is taxed on the difference between the sale price and the amount the employee paid for the shares. The gain is taxed as capital gain. However, this deferral provision does not apply if the employee disposes of the shares within two years of the date the option is granted or within one year after the option is exercised. Incentive stock options are discussed in detail in 381 T.M., Statutory Stock Options.

The problem is that for AMT purposes, an employee is required to recognize AMT income upon the exercise of an ISO. This income increases the employee's basis in the stock for AMT purposes. If the employee later disposes of the stock at a gain, the increased basis offsets an equal amount of the gain and all is well. AMT treatment of ISOs is discussed in detail in 587 T.M., Noncorporate Alternative Minimum Tax.

The issue arises when an employee recognizes significant amounts of AMT income upon exercise of an ISO and later sells the stock at a substantial loss. It seems logical that the employee would be able to carry back that loss and offset the previously recognized ordinary income. But that is not the case. The loss is a capital loss deductible for AMT purposes only to the extent of AMT capital gain plus $3,000. This became an acute problem in 2001 after the market crash of the stock of dot.com companies. Large numbers of employees exercised ISOs in 1999 and 2000 at a time when the underlying stock had substantially appreciated. These employees intentionally waited the one-year holding period before selling the stock in order to recognize capital gain, in contrast to ordinary income, on the stock's appreciation for regular tax purposes. Once they disposed of the stock, it was next to worthless.

Although Congress recently provided some relief in this circumstance by allowing increased use of the AMT credit, taxpayers and their advocates are still fighting this battle in court. There have been several recent cases related to this issue. The arguments posited by tax counsel in these cases supporting the position that these taxpayers are allowed to deduct the AMT losses either against prior income or current income are many and varied. Unfortunately, none of them are working.

In one recent case, the taxpayer argued that the AMT capital losses should be considered net operating losses (NOLs) that can be carried back and used to offset AMT income in prior years.¹ The taxpayer relied in part on the language in §56(d)(2)(A) which allows taxpayers to make adjustments to an otherwise allowed AMT NOL. The taxpayer attempted to argue that this provision allows the taxpayer to add back losses incurred in connection with the sale or forfeiture of ISOs. The problem with this argument is that the wording of §56(d)(2)(A) heavily implies that an adjustment to an NOL can be made only if there is an existing NOL to adjust. The Code specifically prohibits the inclusion of capital losses in an NOL. Allowing the inclusion of a capital loss in an NOL through application of §56(d)(2)(A) is a back-door way around clear guidance to the contrary. The courts appear to agree.

Ironically, the partial relief granted to taxpayers in these circumstances under the Health Relief and Health Care Act of 2006 has actually bolstered the government's position in these cases. In §402 of this Act, Congress provided relief to taxpayers who incurred substantial AMT liability upon exercising ISOs, but were not able to fully use the resulting AMT credit. Beginning in the tax year 2007, a taxpayer is permitted to claim 20% of an unused AMT credit each year, regardless of whether the taxpayer's regular tax exceeds the tentative minimum tax in that year. Of course, in cases still pending regarding the deduction of the AMT losses against prior income, the government is using this new provision to support its cases by arguing that the provision would not have been necessary if there were some other provision in the Tax Code that allowed taxpayers to deduct these losses. In Guzak, the Court agreed with the government and stated that §402 of the Tax Relief and Health Care Act and the corresponding Joint Committee Report confirm the government's interpretation of the Code relevant to the treatment of AMT capital losses.

The possibility of any victory in these cases, despite creative arguments and compelling facts, is remote at best. The assistance provided regarding the use of the AMT credit in tax years beginning in 2007 is welcome relief and does go a long way in helping taxpayers in this unfortunate and arguably unfair position.

For more information, in the Tax Management Portfolios, see Starczewski, 587 T.M., Noncorporate Alternative Minimum Tax, and Reicher, Miller and Welk, 381 T.M., Statutory Stock Options, and in Tax Practice Series, see ¶3410, Alternative Minimum Tax on Noncorporate Taxpayers, and ¶5820, Incentive Stock Options.