Editor: Would you tell our readers about Amper, Politziner & Mattia's Corporate Executive Services Group.
Maglio: The Corporate Executives Service Group works on an ongoing basis as a resource to companies and executives. Typically, with quarterly planning meetings, conference calls and electronic communications throughout the year, we can plan ahead to avoid surprises. The biggest issues that we face include working with clients who are caught with additional taxes due because they were not properly guided on the potential alternative minimum tax (AMT) exposure that could result from their compensation plans, specifically incentive stock options (ISOs).
When engaged by companies to assist their executives, we talk about these issues continuously and develop quarterly tax projections so we can avoid these potential exposures. We can then develop models showing various scenarios so we understand and address these issues long before any action is taken. We work with clients several years in advance of inevitable actions (i.e. option exercises) so that they can take advantage of the windows of opportunity that allow then to exercise their options while minimizing tax exposures and taking advantage of available tax credits.
Editor: The AMT has received a lot of attention with many individuals calling for it to be reformed or repealed. Would you provide our readers with an overview of the AMT?
Maglio: The AMT has received a lot of attention because of the parody between that rate and the reduced income tax rates. All taxpayers perform a parallel calculation of their ordinary income tax and the AMT and pay the higher of the two. As the ordinary tax rates have been reduced, the AMT rate has stayed the same which has led to greater exposure to the AMT.
When calculating the AMT, a taxpayer is unable to take advantage of deductions normally available for ordinary income taxes. For instance, taxpayers normally receive a deduction for the state income taxes on their federal income tax return. Therefore, there is a greater chance that as ordinary income tax decreases because of this type of deduction, the AMT may be higher because these deductions are excluded. Furthermore, specific to corporate executives, the income associated with ISO's is included in the calculation for AMT, while excluded from ordinary income if certain criteria are met.
Editor: In order to attract talented individuals to serve as executives in their organizations, many companies offer stock option grants which may result in payment of taxes under the AMT. Would you tell our readers about the key differences between Nonqualified Stock Options (NSOs) and Incentive Stock Options (ISOs) with respect to the AMT?
Maglio: There is an income tax distinction between the two types of stock options that companies issue executives and employees. An executive or employee who receives NSOs is taxed on the spread between the fair market value of the stock at the time of exercise and the exercise price of the option. That spread is treated as ordinary income and taxed as other wages or bonuses.
ISOs offer executives a preferential tax treatment. That same spread is not considered ordinary income at the time of exercise as long the person holds the underlying shares of stock for one year from the date of exercise and two years from the date the options were granted. If these conditions are met, the taxpayer will pay long-term capital gains tax on the difference between the fair market value of the stock when sold and the strike price of the option.
Despite the advantage of paying tax at a lower long-term capital gains rate rather than a higher ordinary tax rate for ISOs, executives should be aware of the possibility that they will have to pay the AMT in the year the ISOs are exercised. In that year the taxpayer must include the spread between the fair market value of the stock and the exercise price of the option as part of his AMT calculation. As a result there may be AMT due which would diminish the preferential tax treatment that would otherwise be received.
Editor: Does the IRS provide relief for taxpayers who have to pay the AMT because they exercised their ISOs?
Maglio: As long as the executive is not subject to the AMT in the year that the stock is sold, he may be entitled to a credit for at least a portion of the AMT that was originally paid. Also, the resulting gain from the sale of the stock would have a higher basis for the AMT calculation for that year. Any unused AMT credit can be carried forward and applied in years that the individual is not subject to the AMT.
This is a great time of year to begin proper strategizing and planning with clients who have ISOs to avoid these types of exposures. We will typically sit down with a client and orchestrate the timing of stock sales to mitigate their exposure to AMT, discuss the effects of an ISO exercise, and concentrated equity positions while taking advantage of the AMT credits.
Editor: The wave of backdating stock option scandals has raised several concerns for the executives who received them. For instance, many paid the AMT after exercising those options believing they had received ISOs. Is it the practice of the IRS to require these taxpayers to amend their tax returns to show they received NSOs rather than ISOs?
Maglio: I do not believe that the IRS has a policy requiring these individuals to amend their tax returns. However, where a client discovers that there has been an inadvertent backdating of options, we suggest that they go back and amend the return to properly treat the transaction. Where ISOs have been disqualified due to a discrepancy and we are aware of it, it makes sense to correct it.
With respect to the AMT, I believe that the amount of taxes originally paid under the AMT would be treated the same as if there had not been backdating.
Editor: Is the AMT likely to be reformed in the near future?
Maglio: It is such a politicized topic that it is highly unlikely that we will see any immediate changes. If the current Congress decides to increase income tax rates, certain taxpayers may begin to experience less exposure to AMT. Congress may initiate proposals to eliminate the exposure for middle income individuals but I do not believe that there will be an abolishment of the AMT.
Editor: Are there any other taxation issues that compensation committees should take into account when implementing compensation packages for corporate executives?
Maglio: The post-Enron environment has led to a number of different legislative initiatives resulting in a more complex set of issues. This includes Internal Revenue Code Section 409A and other accounting and reporting requirements that must be addressed by compensation committees.
From a corporate standpoint the level of deductibility of certain types of compensation and the expensing of options has put a burden on the company to be more creative in both compensating executives properly and making sure that the company can take advantage of the various expenses related to those compensation packages.
Editor: How can an experienced tax professional work with clients to develop an appropriate executive compensation package?
Maglio: We have found that companies are still trying to sift through new rules like Section 409A. Separately, there is a great deal of misconception on the application of the AMT to stock options and the various administrative requirements for equity compensation plans. I work with companies and the individual executives to give them specific guidance on the intricate issues that Section 409A has created for executive compensation packages so they can address the issues properly and so they do not overlook any potential concerns.
General counsel, board members and benefits professionals have been given this added responsibility which requires them to deal with tax issues that they are not accustomed to dealing with. We can provide guidance to executives that the corporations are not positioned to provide and offer advice that benefits both the executives and the company.
Editor: The SEC requires corporations to file several documents throughout the year disclosing the activities of the corporation with its executives and directors. Why is it important for a company to coordinate these filings with experienced tax professionals and legal counsel?
Maglio: I typically rely on outside counsel and general counsel to handle the SEC aspects of these filings. After Enron, the SEC introduced some more specific guidelines for insider's filings accelerating the time frame for recording and disclosing certain stock transactions. That has enhanced the effect of certain regulations including Rule 16B.
Legal counsel needs to be the guiding force in filing these forms. Many companies have worked with counsel to create specific guidelines for all insiders, officers and directors so they comply with the filing requirements on a timely basis.
Editor: Are the required filings under Rule 16B for insider trading transactions likely to trigger negative tax consequences for an executive and his company if not properly coordinated with other SEC filings?
Maglio: The main concern involves Rule 16B's six month moratorium on trading for insiders and deemed insiders. Some executives attempt to offset a portion of the tax cost resulting from the stock option exercise by selling some of the underlying shares immediately. The key is to time these transactions so that you do not violate Rule 16B's requirements and you have the needed cash available to pay the requisite tax when due. This is most important when an unexpected AMT exposure is recognized upon preparation of an executive's tax return.