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I think I'm finally getting to the point where I understand this, but need some validation. Following are a couple of cases and my interpretation. Could you let me know if I'm on the right track and, if not, point me the right way?

Case 1: Suppose I exercise options (ISOs) to buy 10,000 shares of XYZ at the granted price of \$2.00 per share on May 1, 1997. On that day, the average market price of XYZ (average of high and low prices) is \$8.00. As I read the instructions, my AMT gain is \$80,000 minus \$20,000 or \$60,000. Furthermore, my cost basis for the shares is adjusted from \$2.00 to \$8.00. Is this a correct reading?

Case 2: Complicate Case 1 by assuming the company issuing the options went public on February 1, 1997 and that shareowners were precluded from selling their shares until the end of the lockup period on August 1, 1997. On August 1, 1997, the average market price of XYZ is \$16.00. Does the fact that I was subject to the lockup mean that, instead of a \$60,000 AMT gain, I've got a \$160,000 - \$20,000 = \$140,000 gain?

Case 3: Suppose that, during 1997, I sell \$1,000 shares of XYZ. What is the cost basis? \$2 or the average market price of XYZ established above? The information I've seen says that any gain (loss) is treated as ordinary income because of a sale within one year of exercise of the options. In plain English, where does this go? 1040? Schedule D? Other?

Sorry to be so long winded about this, but I've never had to deal with AMT (or, at least, pay it) before and this has proven to be a tough nut to crack.

John
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[[I think I'm finally getting to the point where I understand this, but need some validation. Following
are a couple of cases and my interpretation. Could you let me know if I'm on the right track and, if
not, point me the right way?]]

As far as additional information, check out IRS Publication 909 regarding the AMT for individuals. It'll give you some additional information. You can read/download Pub 909 at the IRS web site (http://www.irs.ustreas.gov)

[[Case 1: Suppose I exercise options (ISOs) to buy 10,000 shares of XYZ at the granted price of
\$2.00 per share on May 1, 1997. On that day, the average market price of XYZ (average of high
and low prices) is \$8.00. As I read the instructions, my AMT gain is \$80,000 minus \$20,000 or
\$60,000. Furthermore, my cost basis for the shares is adjusted from \$2.00 to \$8.00. Is this a

As far as the AMT issue, you will have an AMT preference in the amount of \$60k. (difference between the option price of \$2/share and the FMV on the date of the grant of \$8/share). And, for AMT purposes, your basis in the shares will be \$8/share.

As far as regular tax goes, your basis will be \$2/share (the actual purchase price). So you will have TWO different basis for the same shares...one for regular tax purposes and another for AMT purposes.

[[ Case 2: Complicate Case 1 by assuming the company issuing the options went public on February
1, 1997 and that shareowners were precluded from selling their shares until the end of the lockup
period on August 1, 1997. On August 1, 1997, the average market price of XYZ is \$16.00. Does
the fact that I was subject to the lockup mean that, instead of a \$60,000 AMT gain, I've got a
\$160,000 - \$20,000 = \$140,000 gain?]]

You lost me on this one. Your AMT issues hit you on the date that the options are GRANTED. If there is no market for the shares at the grant date, then the exercise date will control. What happens down the line, even if you are restricted from making the sale, is not an issue. Certain restrictions MAY cause the ISO to become a regular NQ option, but that is an issue that you'll want to take up with your compensation/benefits folks.

[[ Case 3: Suppose that, during 1997, I sell \$1,000 shares of XYZ. What is the cost basis? \$2 or the
average market price of XYZ established above? The information I've seen says that any gain (loss)
is treated as ordinary income because of a sale within one year of exercise of the options. In plain
English, where does this go? 1040? Schedule D? Other?]]

That is basically correct. You'll have TWO basis for the shares...one for AMT purposes, and one for regular tax purposes. Your cost for regular tax purposes will be what you paid for the shares PLUS the amount that will be treated as compensation on your W-2 form for the early disposition of the ISO. Again, check with your compensation/benefits people in order to get a better fix on how they will handle this internally.

before and this has proven to be a tough nut to crack]]

Right you are. Check out the IRS Pub and you might feel better about things.

TMF Taxes
Roy
No. of Recommendations: 0
<<Case 1: Suppose I exercise options (ISOs) to buy 10,000 shares of XYZ at the granted price of \$2.00 per share on May 1, 1997. On that day, the average market price of XYZ (average of high and low prices) is \$8.00. As I read the instructions, my AMT gain is \$80,000 minus \$20,000 or \$60,000. Furthermore, my cost basis for the shares is adjusted from \$2.00 to \$8.00. Is this a correct reading?>>

I can't improve on Roy's excellent answer to this question. You have a basis of \$8.00 for AMT purposes and \$2.00 for regular tax purposes. If all goes well, you will recoup much or all of your AMT when you sell the stock, by reason of this basis differential and the AMT credit.

<<Case 2: Complicate Case 1 by assuming the company issuing the options went public on February 1, 1997 and that shareowners were precluded from selling their shares until the end of the lockup period on August 1, 1997. On August 1, 1997, the average market price of XYZ is \$16.00. Does the fact that I was subject to the lockup mean that, instead of a \$60,000 AMT gain, I've got a \$160,000 - \$20,000 = \$140,000 gain?>>

Sometimes my fingers get moving too fast on the keyboard and that may have happened here to Roy. As I'm sure he knows, your AMT issues hit you on the date you exercise the options, not when they are granted. (From a tax perspective, nothing reportable happens when the options are granted.) Furthermore, your tax consequences do not depend on whether there is a market for your shares (unless that means they have zero fair market value)--but that wasn't your question anyway.

In your example, the company went public 2/1/97, you exercised \$2 options 5/1/97 when the value was \$8, and were subject to a lockup until 8/1/97 when the stock value was \$16. The question is which date controls for purposes of determining your AMT gain.

A full explanation would be too long for this format, but the following may be helpful. As a general rule, a lockup of this type does not constitute a "substantial risk of forfeiture" under the tax law. Unless there are special circumstances calling for your restriction to be treated as a substantial risk of forfeiture, the value on the date you exercised the option will control your minimum tax consequences. That value would be determined without regard to the restriction because it is a "lapse" restriction, not a "non-lapse" restriction. In short, while I can't answer definitively without talking with you to ask some questions, I believe it's likely that the exercise date will control.

<<Case 3: Suppose that, during 1997, I sell \$1,000 shares of XYZ. What is the cost basis? \$2 or the average market price of XYZ established above? The information I've seen says that any gain (loss) is treated as ordinary income because of a sale within one year of exercise of the options. In plain English, where does this go? 1040? Schedule D? Other?>>

If you sell during 1997, you will have ordinary compensation income equal to the difference between (a) the lesser of the amount realized on the sale or the \$8 fair market value of the stock on the date of exercise, and (b) the exercise price, which is \$2. So if you sell for \$8 or more, you have \$6 of ordinary income (plus some short-term capital gain if you sold for more than \$8). The compensation portion will be included as wages on your W-2, and any short-term gain of course goes on Schedule D. If you sell for less than \$8, your compensation income is equal to the sales proceeds minus the \$2 purchase price. One consequence of this rule is that your AMT income from the exercise of the option and sale of the stock will be the same as your regular income from those events, so you eliminate the AMT effect as to those shares. Of course, you pay a stiff penalty for doing so, in that you have ordinary income as to those shares.

The rule is different if you sell the shares after the end of the year (but still within the 1-year or 2-year ISO waiting period). In this case, your ordinary income will be the full \$6, even if you sell for less than \$8. For example, if you sell for \$7, you have \$6 of ordinary income and \$1 capital loss.

Sorry if this is confusing, I didn't write the laws (but I did write the AMT chapter of the CCH Federal Tax Service).

KAT in Chicagoland