Tax Court Applies Dollar Limitation to ISO Stock Losses in Computing AMT

Palahnuk, (006) 127 TC No. 9

The Tax Court has sustained that an Alternative Minimum Tax (AMT) adjustment claimed by a taxpayer is disallowed if such adjustment stemmed from large losses realized from a sale of stock acquired by exercising an ISO, which caused a large AMT liability in the prior year.

I. What is an ISO:

ISO stands for Incentive Stock Option -- a right to buy a share of stock at a fixed price (called exercise price). It is typically used to compensate upper management to encourage their working enthusiasm.

II. Tax issues regarding ISOs:

When an ISO is exercised, the advantage for taxpayers on one hand is that they need not add the amount of the bargain element (difference between exercise price and market price) into their gross income for the taxable year in which exercise occurs. On the other hand, if the stock is substantially vested on exercise, the price difference is includable in Alternative Minimum Taxable Income (AMTI) as an adjustment.

As a result of AMT treatment, taxpayers can have two different adjusted cost bases, which are used to compute capital gain or loss when the stocks are sold in the future. Specifically, exercise price is considered the regular tax adjusted basis, while market price is the basis for AMT purpose.

In this regard, a couple of tax issues related to future tax liability and AMT come out:

1. The IRS Code does not explicitly address the treatment of capital loss for AMT purposes. Therefore, can capital loss be considered NOL (net operating loss)? And how much is capital loss deductible in computing AMT?
   
2. How is the prior year’s AMT treated as Alternative Minimum Tax Credit to offset future regular tax liability?

III. Case analysis – Jonathan N. Palahnuk vs. IRS:

Facts:

• Jonathan N. Palahnuk was an employee of Metromedia Fiber Network, Inc, and was given ISOs.

• On March 15, 2000, Palahnuk exercised an ISO: Exercise price was $99,949, and market value $2,185,958.

• In 2001, Palahnuk sold the Metromedia stocks: Sales price was $248,410.
  
  Stock sales resulted in, under the regular tax system, realized capital gain of $148,461. Netting with Non-ISO capital loss $153,625, Palahnuk had $5,164 net capital loss. While under AMT method, capital loss amounted to $1,937,547.

Disagreement between taxpayer and Tax Court:

Analysis:

The disagreement in the 2001 tax return between taxpayer and tax court is whether “Adjustment for ISO” claimed by the taxpayer is appropriate. The taxpayer argued that he was entitled to deduct them as a NOL for his 2001 tax return. However, the tax court held that the capital loss was subject to $3,000 limitation whether under regular tax or AMT computation, therefore, no adjustment for ISO could be recognized.

In computing Palahnuk’s AMTI in 2000, the bargain difference was treated as positive tax adjustment, which resulted in acceleration of income items. In 2001, such adjustment might reverse itself when the stocks were sold. Thus Palahnuk should have had the opposite effect (negative adjustment) in AMTI computation. However, Palahnuk realized a capital loss instead of capital gain. The Tax Court held that capital loss did not give rise to an NOL for AMT purpose, per “Merlo, (2006) 126 TC 2056”. Also the Tax Court insisted that the deduction of capital loss was also limited to $3,000 in computing AMTI. In this sense, the negative adjustment for ISO was disallowed.

IV. Conclusions:

1. Based on the Tax Court’s holding, taxpayers can calculate their capital gain/loss for AMT purpose based on their AMT adjusted basis rather than regular tax adjusted basis. However, the deduction of AMT capital loss is subject to the same $3,000 limitation as that of regular capital loss. The capital loss, in addition, cannot be claimed as NOL to be deducted unlimitedly.
    
2. The prior year’s AMT is allowed as Alternative Minimum Tax Credit to offset future regular tax liability. However, because the difference between the recognized capital loss for regular tax and AMT purposes is ZERO, the negative adjustment, which would have been reversed from the prior year’s adjustment, cannot be claimed. Taxpayers’ benefit from Alternative Minimum Tax Credit is restricted accordingly.