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<<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
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