Many people who exercised incentive stock options early this year find themselves in an uncomfortable situation. While they held the stock, hoping to convert their paper profit into long-term capital gain, the value of the stock fell, in some cases dramatically. In this situation it may be best to sell the stock before the end of the year, even though that means reporting profits at the higher rates for ordinary income.
The sale is necessary to avoid paying alternative minimum tax (AMT) on what has become a phantom profit. (This scenario, which more and more optionholders are finding themselves in every year, is covered in detail in my book, Consider Your Options.) Yet there's a trap within a trap for those who want to buy the stock back after selling it.
The AMT Trap
Let's work from an example that illustrates the problem.
In January, Jones exercised an incentive stock option (ISO) she had received over a year earlier, buying 4,000 fully vested shares at $5 when the stock was trading at $105. She had a bargain element, or spread, of $100 per share, for a total of $400,000. Her intention was to hold the stock a little over a year, then sell it for a long-term capital gain. She understood that she would owe roughly $112,000 in AMT the following April, but expected to sell the stock for $400,000 or more before the tax came due and still have a tidy profit. The stock market didn't cooperate with her plan, though. The stock is now trading at $15, so her stake is worth only $60,000.
If Jones continues to hold the stock through the end of the year, the amount of tax she'll owe in April will be greater than the value of the stock. The tax she pays will be eligible for recovery as an AMT credit in future years, but for various reasons it's unlikely she'll recover the entire amount. Even if she could recover the entire credit on her tax return, she's out of pocket more than $70,000 while she waits to recover her credit, because she paid $112,000 in AMT against an actual profit of just $40,000 ($60,000 from sale of the stock minus $20,000 paid to exercise the option).
Escaping The Trap
Jones can escape the trap if she sells the stock before the end of the year. Under the ISO rules, this sale will be a disqualifying disposition (normally a bad move). A disqualifying disposition causes the option profit to be taxed as compensation income, not long-term capital gain. On a sale before the end of the year, though, the profit is measured on the date of sale for both regular tax and AMT purposes. Sure, you'd rather pay tax at a lower rate. But if you have a choice between a high rate of tax on $40,000 or a somewhat lower rate of tax on $400,000, go with the higher rate on the smaller amount!
If Jones sells before the end of the year with a profit of $40,000, her tax is roughly $100,000 less than if she continues to hold the stock. To achieve this tax savings, however, she has to avoid falling into a trap within a trap.
The Wash Sale Trap
Jones wants to take advantage of a rule that limits her income to the amount of actual profit she has on a sale of the stock. This income limitation doesn't apply automatically, however. It's available only if she disposes of the stock in a sale "with respect to which loss (if sustained) would be recognized." That language has been part of the Internal Revenue Code since 1964, but it appears that many financial advisors aren't aware of its significance.
What it means is that the income limitation doesn't apply if you dispose of your stock in a way that wouldn't permit you to deduct a loss. The most obvious example is a gift of the shares. If Jones transfers the shares in a gift (even a gift to a charity) she has to report $400,000 of compensation income because the income limitation doesn't apply. Her profit is measured as of the date she exercised the option, even though nearly all of that profit has vanished by the time she makes the gift.
The same is true if Jones sells the stock to a relative, or to a company she owns. You aren't allowed to deduct a loss on sales to related persons or entities, so the income limitation doesn't apply to such sales. Here again, Jones would have to report $400,000 of compensation income.
Most professionals who deal with stock options are aware of these situations and readily spot the problem with sales to relatives. Yet many appear to be unaware of a third situation where the income limitation doesn't apply. If you buy replacement shares within 30 days before or after a sale of stock, you can't deduct a loss on the sale. This is the notorious wash sale rule. If Jones sells her ISO shares and replaces that stock within 30 days, she loses the benefit of the income limitation. Instead of saving herself $100,000 in taxes, she has cost herself nearly $50,000 in additional tax.
But There's No Loss
The first reaction of tax and finance professionals who haven't encountered this rule before is to say this can't be right. Jones bought the shares for $20,000 and sold them for $60,000. There's no loss on the sale, and the wash sale rule doesn't apply unless you have a loss.
You have to focus on the precise words of the tax law. The income limitation applies only to a sale "with respect to which a loss (if sustained) would be recognized." That means you don't need an actual loss. The question is whether this is the type of transaction on which you would be allowed to claim a loss deduction. A sale and repurchase within 30 days is not a transaction on which you would be allowed to claim a loss deduction, so the income limitation doesn't apply.
Congress made this clear when it put this language in the Internal Revenue Code back in 1964. (At that time it applied to "qualified stock options," the predecessor of today's incentive stock options.) The legislative history specifically mentions the wash sale rule as being one of the provisions that prevent the income limitation from applying. This rule may not be well known, but it appears to be well established.
A Harsh Result
Based on messages I've received, it appears that many professionals are unaware of this rule. Indeed, some prominent finance publications recently commented on the AMT trap while implying, or even stating outright, that there's no problem if you immediately purchase replacement shares. It's likely that many optionees have fallen into this trap.
That's unfortunate, because there's no safe way out. If you make this move, the income tax applies as of the time the ISO shares are sold. (That's true even if you buy replacement shares in the following year, if you buy within 30 days of the sale.) If you sell the replacement shares (and don't replace them), you can claim a loss on that sale. But at this point you have a capital loss, which is limited to $3,000 unless you can absorb the loss with capital gains from other sources.
To put this in perspective, suppose Jones sells her ISO shares for $60,000 and replaces them the next day for the same price. Then she realizes her mistake and sells the replacement shares. The tax law requires her to report $400,000 of compensation income on her disqualifying disposition. She also has a $400,000 capital loss from the second sale, but she can deduct only $3,000. The net increase in her taxable income is $397,000. She'll owe over $150,000 in federal income tax, despite having a real, pre-tax profit of only $40,000. Her only consolation is that any capital gains she has in future years will be tax-free, up to $397,000, because of the capital loss carryforward.
My hope is that the IRS will announce relief from the effects of this rule, but I suspect the chances of that are remote. Optionholders who are in this situation are well advised to avoid making a replacement purchase within 30 days of selling the ISO stock.
Editor's Note: The final ISO regulations the IRS issued on August 2, 2004, confirm by their examples that the wash sale rule applies to ISOs. An automatic purchase of company stock under an ESPP can trigger this treatment, as can option exercises and restricted stock vesting. (See a related FAQ and speak with your tax advisor.)
Kaye Thomas is author of Consider Your Options: Get The Most From Your Equity Compensation, a plain-language guide to handling stock options and other forms of equity compensation. Consider Your Options is available from Fairmark Press.
