A taxpayer who exercised incentive stock options (ISOs), incurring a large alternative minimum tax (AMT) gain in one year and an AMT loss in a subsequent year claimed the right to carryback the loss to offset the gain -- to no avail, according to a recent Tax Court decision (Merlo v. CM, 126 TC #10).
Note: Under the AMT, taxpayers with ISOs generally report gain based on the date the option is exercised, not when the stock is sold, even if the stock subsequently drops in value.
Taxpayer exercises ISOs when the stock is worth $1,001,000 and pays $1,000 as the option price. The difference between the value of the stock ($1,001,000) and the exercise price ($1,000) is called the spread ($1,000,000 in this example). The spread of $1,000,000 is considered an AMT preference item and the tax could be as high as 28% federal ($280,000).
If the taxpayer holds the stock through the end of the year of exercise and the stock drops in value to $10,000, the taxpayer still owes AMT (as high as $280,000) regardless of the subsequent price decline.
Note: If the taxpayer exercises and sells the stock in the same year, the AMT does not apply.
Capital Loss Offset Theory
In Merlo, the taxpayer argued that when he sold his stock in the subsequent year, he incurred an AMT capital loss which offset his prior AMT gain.
In our example, when the taxpayer incurred a $1,000,000 AMT preference, his basis in the stock for AMT purposes became $1,001,000 (the fair market value of the stock). When he sold the stock in a later year for $10,000, the taxpayer's AMT capital loss in the stock is $991,000. Merlo argued he should be allowed to carry back his $991,000 AMT loss to offset his $1,000,000 AMT gain.
Tax Court Response
The Tax Court held that IRC Section 1212(b), which permits capital losses to offset capital gains in the current year and an additional $3,000 of ordinary income (any used capital losses must be carried forward to future years) also applied to capital losses under the AMT. Thus, individual taxpayers cannot carry back AMT capital losses.
The taxpayer in Merlo also argued that the AMT loss should be considered a net operating loss (NOL) which could be carried back for two years. The Tax Court rejected this argument, noting that capital losses are not part of the NOL calculation.
The Tax Court made it clear that any changes in the AMT must originate with Congress and not the courts. IRS takes the same position with respect to offers to compromise tax liabilities based on AMT hardships.
Although AMT victims have lobbied Congress for a fix, thus far, Congress has not responded to the problem. Creative theories such as the capital loss and NOL carryback arguments put forth by the taxpayer in Merlo have been met with a deaf ear by the courts.
In the latest tax legislation passed last week, Congress once again failed to include any AMT offset relief.