IRS to stop taxing incentive stock options that lost money

The IRS will temporarily stop pursuing thousands of Americans who ended up owing large tax debts instead of becoming millionaires after exercising a certain kind of stock option.

IRS Commissioner Doug Shulman said the agency will stop collecting alternative-minimum taxes, penalties and interest owed by workers who exercised incentive stock options only to see their value plummet before they sold. Shulman said the hiatus will be in effect until the fiscal year ends Sept. 30 to give Congress time to pass legislation offering workers relief from the debts.

If the legislation isn't enacted, "the IRS will then continue to administer programs in accordance with current law, and in fairness to the thousands of taxpayers who have already made sacrifices to pay taxes due under this provision," Shulman said in an Aug. 26 letter to Sen. Charles Grassley, R-Iowa.

Incentive stock options receive special tax preferences allowing holders to obtain a lower tax rate on their profits if they hold the stock for at least a year after exercising, typically 15%. Such options were commonly given to rank-and-file employees of start-up companies during the dot-com bubble in the 1990s.

The tax debts built up as workers held their stock in accordance with tax law, even as it dropped in value.

"Taxpayers in this situation faced a lot of income tax on very little income," said Grassley, the top Republican on the Senate Finance Committee. "There's bipartisan consensus to fix the problem. By holding off on collections, the IRS is giving Congress time to act without making things worse for the affected families."

Incentive options differ from ordinary stock options, which are usually exercised and sold on the same day and are taxed as ordinary income at rates of up to 35% no matter when they're sold.

Many taxpayers who exercised incentive stock options, and held on to the shares to get the tax break, fell into a separate tax trap: the alternative-minimum tax, or AMT. The AMT applies to the spread between the option price and the exercise price, regardless of the value of the shares when sold. The AMT rate amounts to 26% on the first $175,000 of income and 28% on amounts above that.

In one example, a man received options that allowed him to buy 100,000 shares of Cisco Systems at 5 cents a share. He exercised the options when they were worth $60 and held the stock.

At the end of the year, they were worth $17 a share, leaving him with a $1.9 million tax bill that exceeded the value of his stock.

Congress voted in 2006 to refund the alternative-minimum taxes over five years. The new legislation would speed up the schedule.

Grassley was joined by lawmakers including Massachusetts Sen. John Kerry, Washington Sen. Maria Cantwell and California Sen. Barbara Boxer, all Democrats, in requesting the new IRS action.

Lawmakers from other states with large high-tech industries also backed the effort.