AMT and Equity Compensation
Alternative minimum tax, nonqualified stock options, incentive stock options and other forms of equity compensation.
ISO AMT & disqualifiying dispositions of private company stock
Posted by: gourd, February 2, 2015 08:25PM

I've read through the Consider You Options 2014 Kindle edition and have questions on ISO strategies of my previous employer's stock options.

The company is privately held and the likelihood of an IPO is pretty low, but an acquisition is the most likely exit (raised several VC rounds of funding).

These aren't my exact numbers, but for illustration purposes similar to my scenario:

250,000 ISO shares @ strike price of $0.10/share, current FMV of $4.00/share.

Exercising would cost $25,000, and the spread is $1,000,000 - $25,000 = $975,000 which would be subject to a huge AMT.

Since it's the beginning of the year, it would be good to exercise early as the book suggests. I was hoping to exercise early and if nothing happened by Dec 31, 2015, I would do a disqualifying disposition.

Regarding disqualifying dispositions, I was told that you could 1) sell/give the stock to a family member or 2) gift to a charity to avoid AMT but that doesn't appear to be the case as stated in chapter 19 ("bad bail-outs") since I would have to report the original spread as compensation.

Is there any tax-favorable scenario where I could exercise in 2015 and do a disqualifying disposition at the end of the year? This is a private company stock which isn't a top tier private company like Uber, Pinterest, etc. so it's not likely that I could sell them on a secondary market (though I am looking at that route just in case). I would be willing to take a loss on the $25,000 to exercise but wouldn't be able to financially pay AMT on the spread & obviously don't want to put myself in that scenario.

thanks for any advice

Re: ISO AMT & disqualifiying dispositions of private company stock
Posted by: Kaye Thomas, February 9, 2015 02:13PM
There are two alternatives, but I don't know if you can rely on either of them. One is some kind of private sale to an unrelated person. Possibly one of the existing shareholders would agree in advance that if you need to bail out at the end of the year, they'll buy the shares in a private transaction. In particular, the company's VCs might be interested in an arrangement that might result in their being able to make a bargain purchase of additional shares. There are both practical and legal issues in trying to line this up and I don't know if this is a workable solution.

The other possibility is rescission. The IRS has a practice of treating a transaction as if it never happened if it is rescinded by the end of the year in which it took place. Rescission means an agreement by the parties to return to the position they would have occupied if the transaction had not taken place. In this case it would effectively mean that the company buys back your stock for the $25,000 you paid to acquire it. The IRS recently undertook a review of its policy regarding rescission, which some people have criticized as overly generous, but an informal announcement indicates they intend to leave the policy in place. In any event, the IRS would not challenge rescission in a case like this because a successful challenge would put you in the position of having exercised the option and sold the stock back to the company within the same year, which has the same tax effect as undoing the exercise.

But can you count on the company being willing to rescind the transaction? On the one hand, it would be attractive for the company to undo the dilution caused by your exercise of the option, assuming nothing has happened to cause a collapse in the stock value during the interim. On the other hand, they may not view it as being appropriate to agree in advance that it will take this step. Any legally binding agreement of this nature would in effect give you a put option, and even though the price for that option is a small fraction of the stock's current value, the company may not find it wise to accommodate you in this way.

I would explore both possibilities. I'm guessing that the more plausible one is an arrangement that allows you to sell the shares to one of the current shareholders, possibly a VC, at a price to be negotiated, with an understanding that the price may be negligible, resulting in a loss of your $25,000. If you find any interest in this idea, you would then have to explore whether you would be able to obtain the requisite legal permissions for the transaction. I have no idea whether you can gain any assurance that you'll have a way out if you need one, but these are the alternatives I would explore.

Kaye Thomas

Re: ISO AMT & disqualifiying dispositions of private company stock
Posted by: gourd, February 24, 2015 08:18AM
thank you for the reply, Kaye.

I spoke with a former employee and he told me the FMV reported in Form 3921 box 4 for his exercise in calendar year 2014 was $0.03 (3 cents), so my FMV of $4.00/share was way way off (this assumption was based on a stock buyback I previously participated in & FMV was higher)

So my follow-up question, given the change in FMV that creates a negative spread between strike price and FMV:

1) since the FMV is less than the strike price, am I safe to assume that I would not be subject to AMT for this exercise since I have a capital loss?

2) if the company has not done a new 409a valuation from a newly raised round of funding, what would they report as the FMV at the date of exercise (say today 2/24/2015)? If it was $0.03 previously, do they just report that (the last 409a valuation is more than a year old)? My 90 day window to exercise will likely occur before they complete a new 409a valuation so I am curious if there is any advantage for me to exercise during this period before a new 409a valuation is determined?

thanks in advance for your insight!

Re: ISO AMT & disqualifiying dispositions of private company stock
Posted by: Kaye Thomas, February 24, 2015 07:27PM
If FMV is below the strike price, there is no AMT adjustment connected with the exercise of the option. (Just to be clear, there is also no capital loss at this point, although a subsequent sale of the stock for a price below the strike price would produce a capital loss.)

I would expect the company to use for this purpose whatever value they're using for 409A purposes, but this should be confirmed with the company. The tax rules merely require FMV, and don't provide detailed rules as to how it should be determined in various circumstances.

Kaye Thomas

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