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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
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whyiswhy 12/5/2012 | 12:36:06 AM
re: Startup Workers Bemoan AMT How to treat everyone equally:

Loans to execs to buy stock should have to be booked as personal income, and taxed as such. The company gave the person a gift with an associated tradable (even if private) paper value. The company also has to put the expense down as payroll cost, like any other (deductable) cost in the company. The net gains between the gift value and the selling price should then be taxed at the lesser of income or capital gains, depending on the time held.
zipple 12/5/2012 | 12:36:06 AM
re: Startup Workers Bemoan AMT ... says Southworth. GÇ£It doesnGÇÖt cost the company anything, because cash is never exchanged. YouGÇÖre just shifting around the equity. I recommend any top executive to get this worked into his/her contract.GÇ¥

Since the cash is never exchanged, what is to prevent a company from offering this sweet deal to all of its employees?
conspiracy theory 12/5/2012 | 12:36:03 AM
re: Startup Workers Bemoan AMT "Since the cash is never exchanged, what is to prevent a company from offering this sweet deal to all of its employees?"

I'll tell you why. There is a conspiracy by execs to keep the troops downtrodden. If you give the troops good benefits, they may just be able to rise up and afford to buy the company out. If that happens, how will the execs (Russo, et al) be able to keep creaming off the millions.
wild_thang 12/5/2012 | 12:36:01 AM
re: Startup Workers Bemoan AMT Actually this all all BS anyway. The article says everyone shoudl exercise as much as they can when stocks are issued to avoid AMT. What the real answer is, is don't try to be greedy and don't risk that money. you should NOT exercise your stocks. whats worse than being hit with AMT, how about owning worthless stocks. The likelihood of success for startups is so low you should not be taking this risk.

There are other ways to minimize risk and still get some long-term tax breaks. Assuming its publicly traded before you exercise which I would recommend. If you exercise in January and then wait and see what happens, in December you can decide whether or not to sell the shares based on what has happened to their value. If they have fallen a great deal you should sell which lets you not be hit with AMT and get out of it what you can. If it is still relatively high you are almost a year vested in long-term tax status and your risk waiting into January to sell is less and you still can sell it for long-term status before the AMT is due on it in Arpil if you need to.

The only people that get hung by AMT are either greedy or stupid (about the tax laws). Personally I don't feel sorry for either of the groups.
gran_poohbah 12/5/2012 | 12:36:00 AM
re: Startup Workers Bemoan AMT "The loan itself doesnGÇÖt 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."

This isn't the way it works anymore. Under recent IRS interpretation the loan must be full recourse. If the stock is the sole collateral then the IRS says the loan is actually income and must be declared as such.
gran_poohbah 12/5/2012 | 12:35:59 AM
re: Startup Workers Bemoan AMT and that is exactly how the IRS interprets a loan used to by stock with the stock being the sole collateral.

LR should do a little more research before allowing bad advice to go unchallenged in one of their articles. C'mon Phil show some invetigative chutzpah here.
Marguerite Reardon 12/5/2012 | 12:35:59 AM
re: Startup Workers Bemoan AMT This is a good point. When I asked Southworth this question he said that it was possible for companies to do it for all employees. He didn't really have a good answer as to why they haven't done this.
gran_poohbah 12/5/2012 | 12:35:58 AM
re: Startup Workers Bemoan AMT Southworth is wrong and ignorant of recent (within the last several years) IRS rulings on this subject.

lorent 12/5/2012 | 12:35:50 AM
re: Startup Workers Bemoan AMT The fact is you can still get screwed if your timing is bad.

I know a guy that excercised in Sept. figuring that if the stock tanked he could always sell by Dec. Unbeknowst to him, the company was looking to raise money and as part of raising the note, all trading by company employees was banned. Until Feb.

So..he ended up with a $300K AMT bill and come Feb. the excercised stock was worth about $50K. So his two years at the company cost him ~$250K. Of course the company stock had deteriorated along with their market so he was also laid off. With a standard two week package. He's been fighting this out with the IRS but chances are they'll end up owning his toothbrush by the time this is over...

Of course the execs structured significantly deals for themselves than the grunts were offered so none of them faced this problem. It shouldn't be that hard for the IRS to come with a structure whereby you pay when you've realized a "true" gain whether you're grunt or a CEO but there's no political will to change.
wild_thang 12/5/2012 | 12:35:36 AM
re: Startup Workers Bemoan AMT Classic example.

As I said exercise in January, then come december you are past the typicsl holding period (6 months) which is what made him not be able to sell his stock. If you do it as I mentioned you won't have that problem either. your only risk is from say December 31 (assuming its not a weekend and the market is open) and January 2nd (or the first day the market is open in the new year).
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