Whether it’s Silicon Valley, Silicon Beach or Silicon Prairie, working with clients in the startup world comes with a host of unique issues. In many ways, it’s a wild roller coaster not for the faint of heart. Will the startup client succeed and create an initial public offering or will it simply fail and quietly fade into the night? With these high stakes outcomes at play, what complicates these clients’ financial issues can be incentive stock options that are usually granted to founders and the people that join a company early. If ISOs are handled correctly and the stars align, it can be a story of great wealth and insightful tax planning. But when ISOs go awry, as they often do, it brings into play the perils of the alternative minimum tax.
In normal times, most clients find it challenging to fully understand the risks and long-term implications of exercising and holding ISOs. For clarity purposes, we often label regular AMT based on preference items as “bad” AMT, and the AMT credit generated by ISO exercises as “good” AMT. Further, in high tax states like California and New York, clients are often committing to a multi-year strategy—first, the exercise of options, then the use of AMT credits in the years when they’re not subject to AMT.
But these aren’t normal times. And on Nov. 2, 2017, the Tax Cuts and Jobs Act added another layer of complexity for startup participants to navigate. Depending on how this tax bill plays out, those of us with ISO clients will have to make relatively quick decisions on how to advise them—and we need to be calculating their best next steps.
The Usual Fact Pattern
Many clients are committed to a multi-year ISO/AMT strategy. Typical clients exercised pre-IPO ISOs when the Internal Revenue Code Section 409A valuation was increasing. In exercising their ISOs, they undertook to carry AMT credit on Form 8801 until they were in a year when they weren’t subject to AMT. At this point, they would use their credits to offset their regular tax bills. It’s a calculated strategy.
The new tax bill could potentially undermine this strategy. Under the bill, the AMT credit carryforward won’t be available in 2018. It’s scheduled to come back in 2019, 2020 and 2021, but would only allow the taxpayer to claim a refund of 50 percent of credits to the extent the credits exceed regular tax for the year. Any remaining carryforward can then be used in the 2022 tax year.
Put simply, if your clients don’t act by Dec. 31, 2017, they might not be able to benefit from their AMT credit carryforward for almost six years—a long time to wait, given the time value of money.
For Some, Action May Be Necessary
What can be done when we have limited time to help these clients? If a client has ISO stock that he acquired in a public company, the first step is to review his equity awards for non-qualified stock options. Markets are at an all-time high, so pulling the trigger and generating ordinary income to use up some or all of the AMT credit might be the best course of action. (Note, this might not be a solution for an insider who’s restricted.) If there are no NQ stock options available to exercise and sell, then you need to check to see if any other ordinary income can be generated.
If your client isn’t able to use all of the AMT credit, then you must properly set expectations with the client. Waiting for a tax benefit can be like watching water boil. Proper explanation of the delay will help. And be sure to continue to file Form 8801 tracking the credit.
However, in all this planning, be careful to not make absolutes. By accelerating income to use the credit, consider if it benefits the client over the long term if in future years the client could have exercised NQ stock options at a lower federal rate.
Another issue that clouds the analysis relates to state law. If the federal law changes in regard to AMT carryforward, you also need to consider the impact if the state doesn’t piggyback.
For Others, Nothing Can Be Done
For those clients with ISOs in a private company, the planning process is even more frustrating. There are only limited opportunities to use the AMT credit prior to Dec. 31, 2017, including:
- Take into consideration the size of the AMT credit in play. A nominal credit can be held and used in 2019.
- In some situations, a partial disqualification may be worth considering.
If these steps don’t help, it comes back to setting proper client expectations on when the credit may possibly be used.
Timing Is Key
Ultimately, the new tax bill may be a monkey wrench in the plans of many clients who exercised ISOs and generated AMT credit. Timing is key, as is thinking through all the moving parts related to going down a certain path. You need to find the balance between getting out in front of your clients on actively planning by year-end and the risk of being drawn into any absolutes. Keep in mind that these suggestions are merely a first step. We’ll gain more clarity on the best way to proceed as the situation plays out.