Startup Workers Bemoan AMT
After further investigation, Light Reading continues to find cases of networking employees being snagged by the stealthy alternative minimum tax (AMT) (see No Relief for AMT Sufferers).
The latest reports of the AMT-bitten include workers at startups with illiquid stock who are stuck with unpayable tax bills. At the same time, these workers point out, the executives at some startups can purchase their stock with special loans that shield them from the same problems.
One former Cyras Systems employee, who didn’t want his name used, exercised a portion of his allotted options when they were granted to him. Six months later he exercised more, but the value of the company had increased, making each share worth much more than his strike price.
“I didn't realize the problem until the next year at tax time,” he says. “But even if I did, I had no way to sell my shares, because it was still a private company. I ended up paying about $60,000 of AMT.”
The company was then sold to Ciena Corp. for $2.6 billion (Nasdaq: CIEN) (see Ciena To Buy Cyras for $2.6 Billion). Finally, when a portion of his shares was vested, he was able to sell them to pay off some of his debt.
The scenario and risks differ greatly based upon the value and stage of the startup, but one thing is clear: It is not easy to understand and navigate all the tax implications of the AMT -- and employees should pay attention to how and when their options are being valued and exercised.
In very early-stage startups, companies might issue options for a few pennies. But the strike price increases for new employees as the valuation of the company increases. If an employee decides to exercise his options when they are issued, he can avoid paying AMT, because the strike price and the market value of the options are equal. Many tax professionals would advise that this is a good time to purchase any vested shares and pre-purchase any unvested options, if at all possible.
“If you started with a company after the series A round, and the price of the options are low enough, it’s a no-brainer to buy all the shares you can,” says Michael Southworth, a certified public accountant and former financial executive for the metro division of Lucent Technologies Inc. (NYSE: LU).
If the employee waits to exercise his options after the value of the company has increased, he will likely be hit with AMT for the year in which he exercised those options. The AMT is calculated based on the spread between the strike price and the fair market value of the shares. Whether or not the company is publicly traded at the time the options are exercised is irrelevant, says Southworth.
Another potential pitfall is failure to file an 83(b) election within the allotted 30-day requirement. This form must be filed to the Internal Revenue Service by an employee who has exercised unvested options based on a predetermined vesting schedule. If the employee doesn’t file the 83(b) form, the gains on those options will be taxed as they vest.
But many startup workers aren’t willing to risk too much cash on options upfront. Michael Southworth was a corporate controller at Chromatis before the company was acquired by Lucent for $4.5 billion (see Lucent Catches Chromatis). Southworth says he knew the dangers of AMT and tried to minimize his exposure as best he could. Because he had begun working for Chromatis after its Series C round of funding, it was too expensive to purchase all of his unvested shares at once. So he waited until it looked as though Chromatis would either be sold or would go for an initial public offering.
Just before Lucent acquired Chromatis, he exercised a portion of his shares. But because he was not vested yet, he was unable to sell the newly converted Lucent stock on the open market after the merger was completed. By the time he was able to sell his shares, the company’s stock had declined sharply. In the end, Southworth was not only hit with a heavy loss, but he had a tax bill worth over $200,000. He observes, though, that it could have been a lot worse, had he not planned the subsequent exercise and sale of his additional options to pay off this bill.
"I wasn’t crippled by the tax,” he says. “I knew what I was getting into. Of course, I didn’t want to have to pay as much as I did."
Unlike the rank-and-file employees at startups, who must weigh the risks of huge tax bills versus losing cash if the startup tanks, some startups give their top executives non-recourse loans to purchase pre-vested options early. The options are usually offered at the company’s current valuation, avoiding AMT.
The loan itself doesn’t affect an executive's personal credit ratings, because the shares themselves are what is used as collateral for the loan. If the company files for Chapter 11 bankruptcy protection or goes out of business entirely, the executives simply give back the worthless shares.
“I’ve always been very supportive of these loans,” says Southworth. “It doesn’t cost the company anything, because cash is never exchanged. You’re just shifting around the equity. I recommend any top executive to get this worked into his/her contract.”
— Marguerite Reardon, Senior Editor, Light Reading