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For many stock optioners, their state and federal tax bills this year were based on 'paper profits' rather than on money they received from selling their stock.
Photograph by Paul Myers
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Tax Broke
Stock optioners who once dreamed of financial security, now have nightmares trying to figure out how to pay millions in taxes for money they say they never saw
By Sandy Sims
'I never felt like my money was real," says Sheryl Johnson. "But never in my wildest dreams did I think you could be taxed on money you never got." A little more than a year ago, stock options seemed to be California's new gold. Workers like Johnson were willing to put in long hours with little pay for a gamble on stock options. With high-tech stocks climbing at a frenzied pace, optioners had visions of early retirement and being fixed for life financially. And the U.S. economy was soaring in good part because of these workers.
Then last year the market lost steam. Dot-com companies started shutting down, and within months, optioners' dreams turned into nightmares. This year optioners found themselves with tax debts in the hundreds of thousands or millions for money they claim they never really possessed.
Now optioners are mortgaging their homes, cashing in their retirement plans, borrowing from relatives and declaring bankruptcy. For many, interest and penalties are accruing on taxes they can't afford to pay.
This tax catastrophe is so widespread in California that the State Franchise Tax Board has added a panel of specially trained tax agents to deal with stock option casualties. And it isn't just high-tech workers who are affected. In all types of businesses, stock options have become as common as 401Ks or health benefits.
Stock optioners say they didn't see this coming.
When former Los Gatan Sheryl Johnson, who works in marketing communications at Turnstone Systems Inc., a manufacturer of hardware and software for Internet applications, became aware of the value of her incentive stock options (ISOs) last year, she got herself a financial advisor. "I wasn't smart enough to know what to do with that much money," she says.
A financial advisor and a certified public accountant both told her to exercise her option, which meant buy the stocks at the reduced rate the company granted her. Her advisors also told her to hold the stocks to qualify for long-term capital gains, which would be taxed at a lower rate.
Johnson followed the recommendations, bought the stock on Jan. 3, 2000, and held onto it. According to tax rules, after Dec. 31, 2000, her tax liability shifted to the Alternative Minimum Tax.
Alternative Minimum Tax, or AMT, is a complicated tax system that parallels regular income tax. Certain financial conditions, such as large tax deductions, can force taxpayers to have to calculate their taxes using the AMT. The AMT tax figuring system is always triggered when a taxpayer exercises incentive stock options in one year and holds the stock into the next.
"I knew I would have to pay AMT; I just didn't know how much," Johnson says.
According to Saratogan Henry Yamate, a longtime certified public accountant, AMT (for incentive stock options) is calculated on the difference between the low option price and the fair market value of that stock on the day it's bought--essentially a paper profit. Holding on to the stock for a year means long-term tax gain and a lower AMT rate, Yamate explains.
Johnson planned to sell enough stock in April to pay her AMT for the year 2000, hold on to the rest of the shares, and maybe sell some when she gets married in November for a down payment on a house.
Then the stock market began to tumble. When tax time came around in April, the 34-year-old's tax bill was $225,000 based on the paper profit she made on January 3. But by then, the stock's value was so low that even if she sold all of it, there wouldn't be enough money to cover her tax bill. "Everything would be gone," Johnson says.
The government has you trapped, Yamate says. "You never actually get the money, but the IRS says you did on the day you exercised your option." Some financial advisors argue that a person does gain monetary value on the day the stock option is exercised, and that the optioner gambles by holding on to the stock, which could go up or down.
Johnson is one of thousands of incentive optioners with enormous AMT bills. Some owe millions for what they are calling "phantom money."
This tsunami in taxes hit taxpayers across the board: receptionists, CEOs, information technologists, secretaries. All ages, including those in their 50s and 60s have been forced to find ways to pay their tax bills. Many just don't have the resources to afford the expense. Some owe money on stock that's worthless because the company folded.
"AMT isn't fair," Johnson says. "You should only pay taxes on money you actually receive."
The AMT was enacted in 1969, following testimony by the secretary of the treasury who reported that 155 individuals, each with an adjusted gross income of more than $200,000 (worth about $1.1 million in fiscal year 2000) paid no federal income tax in 1966.
Experts, including the U.S. General Accounting Office agree that AMT is no longer doing what it was meant to do--force the wealthy to pay their fair share of taxes.
Until just a few years ago, the only people who benefited from incentive stock options were high-end executives. But now stock options are being doled out to everyone. Start-up companies use them in place of compensation and lure employees to work long hours for little pay while the business is establishing itself. Larger companies include stock options as part of hiring packages to entice new workers.
The AMT system, however, doesn't recognize that the middle class has become a player in the stock market. Nor does it allow for the kind of wild swings the stock market has experienced in the last couple of years.
Photograph by Paul Myers
Sheryl Johnson and some 600 incentive stock optioners have formed a grassroots organization to fight current Alternative Minimum Tax laws.
Johnson and others from around the nation who are trying to dig out of this tax hole are hoping for a miracle.
And they are taking action.
Johnson and some 600 others from 26 states have joined Reform AMT, an organization devoted to addressing this perceived injustice.
In an I'm-not-going-to-take-this-sitting-down stance, hardware engineer and incentive stock optioner Jeff Chou set up a Reform AMT website (www.reformamt.org) this year and says he is getting a big response.
Chou found himself stuck with a $2.5 million AMT bill. "Everything encourages you to hold on to stocks," Chou says. He explains that long-term tax gains are meant to encourage long-term investment. He says, "The company doesn't want you to go out and sell all your stock either."
"If I sold everything I own in the world, I will still be six figures in the hole for my taxes," says Chou, who lives in a condominium with his wife and baby. "I would lose everything I own and everything I worked hard for," he says.
Chou says he asked one of the executives at Cisco Systems--where Chou received his incentive stock options--what to do. "He told me the law is the law and to hold on to my stock and hope it goes up," Chou says. That wasn't enough for Chou.
"I'm fighting it all the way. What have I got to lose?," Chou says.
Chou paid his state taxes and is working with a tax lawyer, hoping to work something out with the IRS.
But that's not all he's done.
Chou has flung his story out to the public. Most people don't want to go public because the dilemma facing optioners is so personal. They feel a sense of shame, Chou explains. "But if we don't tell our story, no one will know," he says. Chou compares this tax catastrophe to a natural disaster. "So many of us have lost everything," he says.
Public opinion, however, is adding insult to injury. When Chou set up his website, he received a slew of hate email. "People are calling us 'rich whiney dot-comers who lost and want the government to bail us out.'" Some sent email saying, "You got what you deserve." Others said things like, "You make me sick."
"It's tough to hear these things over and over when you are fighting bankruptcy," Chou says. The stress of these taxes is taking its toll on many people. "It's hard for us to grasp what's happened," he says. "One woman I know is physically sick from it. She's vomiting, and her hair is falling out. We are all losing sleep."
By April of this year, Congresswoman Zoe Lofgren, who represents California's 16th district, which includes San Jose, had heard enough incentive stock option and AMT stories from her constituents, that she wrote congressional bill HR 1487.
If the bill passes, workers who exercised incentive stock options would be taxed only on actual gains from selling their stock, not on the paper profits figured on the day they exercised their options. The bill would make the change retroactive to 2000. To date there are 46 bi-partisan co-sponsors of HR 1487, 10 of them Republicans, including Tom Davis, head of the National Republican Congressional Committee.
Chou is not very optimistic about Lofgren's bill because it's retroactive. He says Congress rates the cost of every bill, and according to the Joint Committee on Taxation, this bill, as it is now written, would cost the treasury an estimated $13.8 billion through the year 2010. Since the recent tax cut, Congress doesn't look favorably on expensive bills.
In late June, however, U.S. Sen. Joseph Lieberman introduced Senate Bill 1142 that would eliminate AMT for workers who exercise incentive stock options. This bill would not be retroactive, and all those caught in this year's quagmire of high taxes and low stock prices would get no relief.
"Lobbying for Reform AMT is expensive," Chou says. "None of us have any money." He says every time the organization sends out a press release, it costs about $700. "We are hoping to pick up an angel that will donate money to our cause," Chou says.
Photograph courtesy of Sheryl Johnson
Stock option recipients who have been hit with enormous tax bills rally before a town hall meeting with Congresswoman Zoe Lofgren and Congressman Robert Matsui.
In June Reform AMT organized a town hall meeting that met in San Jose City council chambers. Lofgren and Congressman Robert Matsui from Sacramento both attended. Matsui serves on the Committee on Ways and Means, which reviews tax laws.
After a rally outside city hall with optioners brandishing placards reading: "Guns don't kill people. AMT kills people" and "Will work for AMT," some 300 people filed into the chambers, and one by one they strolled to the microphone telling of owing, in some cases, millions of dollars in taxes.
In videotaped testimony, a man ready to retire told how his house had been almost paid off until AMT left him with a six-figure tax bill and another mortgage on his house. "This tax law is destroying lives," he said. One woman recalled the Boston Tea Party in memory of unfair tax laws. "At least the IRS could suspend interest and penalties," said one man.
Some speakers carried messages from people outside of California who wanted it to be know that this is not just a Silicon Valley problem: A man in Austin, Texas, owes $230,000; a woman in Massachusetts owes $340,000.
Matsui explained that AMT isn't a regional problem, and it's affecting more and more people in the middle class. The major reason cited for the increased effect on lower-income earners is that the law has not been indexed for cost of living over the years. Major deductions can trigger AMT, including such things as a high number of dependents, large medical bills or a large state income tax. Passive incomes such as dividends, rent and interest can also trigger AMT. Once taxpayers shift into the AMT system, they cannot take most of the regular deductions, thus allowing AMT to tax more of their income.
Kathy Roeder, press secretary to Congressman Matsui, says that taxpayers in states with high state and local taxes are more susceptible to AMT. For example, Roeder explains, according to a projection prepared by Democratic members of the Ways and Means' Committee's staff, a family with three children in California in 2006 making $87,800 will have to figure taxes by AMT.
Repealing AMT has been a longtime Republican issue. According to Greg Crist, press secretary to House Majority Leader, Congressman Dick Armey, in 1999 the Republican-controlled House and Senate passed a bill repealing AMT. President Clinton vetoed the bill. By 2010, Crist says, eight to 10 million Americans will be paying AMT. Crist says he was not aware of the stock option problem.
According to testimony by the U.S. General Accounting Office to the U.S. Committee on Finance, the number of taxpayers affected by AMT under current law is projected to expand from about 1.3 million in 2000 to about 17 million in 2010.
The repeal of the AMT could cost some $300 billion in revenues.
Besides those adversely affected by AMT, there is another even larger category of stock optioners who have been hit with unexpected tax bills. This group received what are called non-qualified stock options. The law requires non-qualified stock optioners to pay their taxes the day they exercised their options. Most of them sold enough stock to pay their tax bill and then held on to the rest of their shares. When tax time rolled around this year, these optioners were slammed with hundreds of thousands in additional taxes because, unknowingly, they hadn't paid enough tax the first time around. But some were faced with near worthless stock, which meant no assets to pay the additional tax bill.
Photograph by Paul Myers
Los Gatan Deborah Vinick thought she had paid enough taxes when she exercised her non-qualified stock options, but she wound up owing $150,000 more after her stock lost its value.
Los Gatan Deborah Vinick, 35, was caught in this imbroglio. Vinick went to work for Cisco Systems as a project manager in 1998, before stock options meant much. But she was granted non-qualified stock options, nevertheless. More thrilled that she got a good job, stock options were just an extra benefit that she paid little attention to, she says.
Then Cisco's stock increased in value as the dot-com bubble expanded. Pretty soon Deborah was getting rich on paper. After four years at Cisco, Vinick decided to move on to another company. According to the law, she had to exercise her stock options within three months of leaving Cisco. She did, and her tax was figured on the difference between her stock option price and the fair market value of the stock the day she sold it.
The tax law sees the paper gain for non-qualified stock optioners as a bonus and treats it like regular income, Henry Yamate explains. Companies are required to withhold taxes at flat rates of 28 percent for federal taxes and six percent for California. Vinick bought and then sold enough of the stock to pay $350,000 in taxes. She thought this was the extent of her bill. On the advice of her financial advisor, she held the rest of the stock for long-term gain tax benefits.
Come tax time Johnson learned that her federal and state tax rates were considerably higher. She owed another $150,000 because she was actually in a higher tax bracket. By then her stock value had evaporated and would no longer cover the tax bill. "I live in an apartment and have an old car," Vinick says. "Where would I get that kind of money?"
Vinick's mother, a retired widow, took out a $150,000 mortgage on her house. "The loan is in her name, but I pay the monthly payment of $1,100. The government has made out like a bandit," Vinick says. She and her mother have decided to pay the mortgage for two years and see what happens with the stock.
Vinick is hanging on to the stock in hopes it will go up enough, for her to sell it and pay off the loan.
Many optioners are hanging on to their stock, hoping it will rally. In fact, everyone is hoping the stock market will rally. But each day the news gets a little grimmer. Sheryl Johnson, is getting nervous because in April she took an extension on her taxes, and the interest and penalties are accruing on her tax bill. Jeff Chou says one of his friends just got a notice that the IRS is going to levy his house.
"I'm waiting for a similar letter from the IRS," Chou says.
Chou is banking on an act of Congress. Lofgren's bill HR 1847 is now in the Ways and Means Committee, but Chou says most lawmakers don't think it will pass. He's working with lawmakers on other pieces of legislation that offer potential fixes for incentive stock optioners caught in the AMT this year.
"We have to work fast, because Congress will be taking a break soon," Chou says. He says he's been told that if they are to get anything through Congress, this is the year because next year many of the representatives will be campaigning and not available.
"AMT is on the radar screen of everyone in Congress," Congressman Matsui's press secretary Kathy Roeder says. "There's a consensus that AMT no longer fulfills its original intention." Roeder says she believes it's just a matter of time before AMT is reformed, but it may be too late for this year's stock optioners.
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