Stock Options and AMT: Tax Court Says No Hardship

The Tax Court ruled, in Speltz, 124 TC No. 9 (2005), that an IRS Appeals Officer did not abuse discretion in rejecting a Sec. 7122 offer-in-compromise (OIC) when the taxpayers incurred a large alternate minimum tax (AMT) liability on the exercise of incentive stock options (ISOs). The AMT liability greatly exceeded the taxpayers selling price for the stock, thereby creating a serious economic burden and lifestyle changes for them and their family. The court also interpreted 1998 changes to Sec. 7122.

Background

Sec. 7122 authorizes compromise of any civil or criminal case arising under the internal revenue laws. In 1998, Sec. 7122(c) and (d) were amended for OICs and installment agreements. Sec. 7122(c)(2)(A) specifies that an OIC should allow a taxpayer to have adequate means to pay basic living expenses. Regs. Sec. 301.7122-1 provides three grounds for compromise: doubt as to liability, doubt as to collectibility and promotion of effective tax administration. Under the third ground, compromises are allowed to prevent economic hardship. Factors supporting a finding of economic hardship include a taxpayers inability to earn a living due to illness, and the need to support dependents with the income and/or assets he or she has. Examples are provided; see Regs. Sec. 301.7122-1(c) (3)(i) and (ii).

Regs. Sec. 301.7122-1(c)(3)(iv) allows compromise when, due to exceptional circumstances, collection would undermine public confidence that tax laws are being administered fairly. An example would be a taxpayer who learns at audit that he was given erroneous tax advice and is facing additional tax, interest and penalties. Section 5.8.11.2.2 of the Internal Revenue Manual (IRM) points out that such compromises will be rare, because it would undermine Congresss will if the IRS found that particular tax statutes were unfair. Also, there would be unequal treatmentsome taxpayers would fully pay their tax liability, while others would have theirs compromised due to perceived unfairness in the law.

Secs. 421(a) and 422 defer regular Federal income tax on the exercise of ISOs. However, AMT is imposed on the exercise of such options under Sec. 56(b)(3).

Facts

Ronald Speltz earned $75,000 at McLeodUSA (McLeod) in 2000, which increased to $90,000 by 2004. In 2000, he exercised McLeod ISOs, re-sulting in $206,191 of AMT, even though joint adjusted gross income was $142,070 and regular tax on his joint return was only $18,678. The return showed a liability, after withholding, of $210,065. The Speltzs paid $17,565 with their return and $75,000 in installments prior to November 2001. They borrowed $134,000 from a bank to pay their 2000 Federal and Iowa taxes. (The Iowa AMT was $46,792.)

In November 2001, they submitted Form 656, Offer in Compromise, with $4,457, the cash surrender value of Ronalds life insurance policy. Their unpaid 2000 Federal tax liability exceeded $125,000 at that time. They stated that they had insufficient income and assets to pay the remaining liability and explained that they had three young daughters, Mrs. Speltz had to get a job due to the AMT liability, one child had to switch schools and they were unable to save for their childrens education. Also, their McLeod stock, which secured the $134,000 loan, was nearly worthless.

In October 2002, when the unpaid tax liability was $148,745, an IRS Revenue Officer rejected their $4,457 OIC, determining that they had the ability to pay, considering their assets and future income. In December 2002, the IRS sent them a Notice of Federal Tax Lien Filing and Your Right to a Hearing Under IRC 6320, which they requested. In August 2003, after a telephone conference with an IRS Appeals Officer, the Service sent them a Notice of Determination, which stated that the lien was correctly filed.

The Speltzs appealed to the Tax Court, arguing that the AMT liability due to the ISO exercise was unfair, as it imposed a 220% tax rate, and that Congress intended Sec. 7122 to provide relief in such situations. The IRS countered that the Appeals Officer correctly applied the statute, the regulations and the IRM.

Opinion

The Tax Court ruled that the Appeals Officer did not abuse his discretion in refusing to compromise their $148,745 tax liability for $4,457, reasoning that Sec. 7122 does not allow it to make adjustments to complex tax laws on a case-by-case basis. While recognizing that the literal application of the AMT has led to a perceived hardship in many cases, the court pointed out that previous decisions have rejected challenges to the AMT based on equity considerations.

The Tax Court added that the taxpayers were asking it to redefine hardship, special circumstances and efficient tax administration, but the explanations of these terms in the regulations and IRM are not unreasonable. The court concluded that Congress is aware of the claimed inequities of the AMT, and only Congress can correct them. Noting that the Speltzs will have an opportunity for another Appeals hearing before any levy on their assets, the Tax Court suggested that they might want to submit another OIC at that time.

Conclusion

The problem in Speltz is that the taxpayers were being taxed for AMT purposes on the receipt of noncash compensation (the ISO exercise), but losses on the stocks subsequent sale could not be used to offset the AMT liability. Ideally, the taxpayers should have sold sufficient McLeod stock to pay the AMT as soon as they exercised the ISOs; instead, they made an OIC, for which hardship is narrowly defined in the Sec. 7122 regulations and IRM. Typically, if a taxpayer has sufficient current and future assets to cover basic living expenses (including dependent care and support), he or she has not shown hardship. Unfairness of the tax laws is very difficult to prove, as it involves separation-of-powers issues.

Some companies have replaced stock options with Sec. 83 restricted stock, which does not trigger an AMT issue. However, President Bushs Advisory Panel on Federal Tax Reform, which is currently studying alternatives for Congress to consider, may be the best chance for a solution to the AMT quandary.

From Peter C. Barton, MBA, CPA, J.D., Professor of Accounting, and Roy C. Weatherwax, Ph.D., CPA, Professor of Accounting, University of WisconsinWhitewater, Whitewater, WI (Not affiliated with Baker Tilley International)