[Congressional Record Volume 147, Number 93 (Friday, June 29, 2001)]
[Senate]
[Pages S7197-S7199]
From the Congressional Record Online through the Government Publishing Office [www.gpo.gov]

      By Mr. LIEBERMAN:
  S. 1142. A bill to amend the Internal Revenue Code of 1986 to repeal 
the minimum tax preference for exclusion for incentive stock options; 
to the Committee on Finance.
  Mr. LIEBERMAN. Mr. President, today I am reintroducing a proposal 
with regard to the perverse impact of the Alternative Minimum Tax, AMT, 
on Incentive Stock Options, ISOs. I previously introduced this proposal 
on April 30, 2001, as Section 5 of S. 798, the Productivity, 
Opportunity, and Prosperity Act of 2001. I am reintroducing this 
proposal as a separate bill to highlight the importance of this issue.
  Incentive stock options and the AMT did not exist when Franz Kafka's 
``The Castle'' was published in 1926. The book describes the relentless 
but futile efforts of the protagonist, K., to gain recognition from the 
mysterious authorities ruling from their castle a village where K. 
wants to establish himself. The world he inhabits is both absurd and 
real. Kafka's characters are trapped, and punished or threatened with 
punishment before they even have offended the authorities.
  The AMT/ISO interaction would be one that Kafka would appreciate. In 
the case of ISOs an employee who receives ISOs as an incentive can be 
taxed on the phantom paper gains the tax code deems to exist when he or 
she exercises an option, and be required to pay the AMT tax on these 
``gains'' even if the ``gains'' do not, in fact, exist when the tax is 
paid. This means the taxpayer may have no gains, no profits or assets, 
with which to pay the AMT and might even have to borrow funds to pay 
the tax or even go into default on his or her AMT liability.
  This Kafkaesque situation is unfair. It is not fair to impose tax on 
``income'' or ``gains'' unless the income or gains exist. With the AMT 
tax on ISOs, it is not relevant if the ``gains'' exist in a financial 
sense. That they exist on paper is sufficient to trigger the tax.
  This situation is also inconsistent with many well-established 
Federal Government policies. For example, our country favors stock 
options as an incentive for hard-working and productive employees of 
entrepreneurial companies. In most cases, entrepreneurs take enormous 
risks, receive less compensation than employees working for established 
companies, and have no company-sponsored pension plan. In addition, our 
country favors employee-ownership of firms. This ownership gives these 
employees a huge stake in the success of the company and motivates them 
to dedicate themselves to the firm's success. Finally, our country also 
favors long-term investments that generate growth. We know that growth 
is most likely to arise when entrepreneurs take risks over the long-
term and build fundamental value for their companies and shareholders 
and owners. The policy favoring long-term investments is reflected in 
the fact that capital gains incentives are available only if an 
investment is held for at least one year. An investment sold before the 
end of this ``holding period'' receives no capital gains benefit. The 
application of the AMT to ISOs is inconsistent with all three of these 
public policies.
  Let me explain the difference between ISOs and NSOs. Incentive stock 
options are sanctioned by the Internal Revenue code. Under current law 
the employee pays no tax when he or she exercises the option and buys 
the company's shares at the stock option price. The company receives no 
tax deduction

[[Page S7198]]

on the spread, the difference between the option price and the market 
price of the stock. If the employee holds the stock for two years after 
the grant of the option and one year after the exercise of the option, 
he or she pays the capital gains tax on the difference between the 
exercise and sale price on the sale of the stock. The tax payment is 
deferred until the stock is sold and the tax is paid on the real gains 
that are realized from the sale.
  NSOs are stock options that do not satisfy the tax code requirements 
for ISOs. They are ``non-qualifying stock options'' or NSOs. With NSOs 
the employee is taxed immediately when the option is exercised on the 
spread between the grant and exercised price. This forces an employee 
to sell stock as soon as he or she exercise their options so that they 
can pay the tax on the spread. This is a zero sum game for the 
employee, selling the stock he or she has just bought to pay a tax on 
the spread. Even worse, because the stock is not ``held'' for one year, 
this tax is paid at the ordinary income tax rates, not the preferential 
capital gains tax rates. The company receives a business expense 
deduction on the spread.
  If this were the whole story, it is clear that companies would tend 
to offer ISOs rather than NSOs to their employees. Employees would be 
encouraged to hold their shares for at least a year after the option is 
exercised, which helps to bind them to the company. They would then 
qualify for capital gains tax rates on the realized gains.
  The problem is that ISOs come with a major liability, the application 
of the Alternative Minimum Tax, AMT, to the spread at the time of 
exercise. This tax is due to be paid even if the stock is held for the 
required period and even if the stock is eventually sold at a fraction 
of its value at the time the option is exercised. This tax at the time 
of exercise is inconsistent with the rule that applies to all other 
capital gains transactions, where the tax is paid when the gains are 
``realized,'' when the investment is sold with gains or losses. This 
tax at the time of exercise defeats the purpose of ISOs, forces 
employees to sell their stock, to pay the AMT tax, before the end of 
the holding period, and pay ordinary income tax rates. The difference 
between ordinary income tax rates and capital gains tax rates can be 15 
percent or more.
  The AMT tax is imposed on the spread at the time the option is 
exercised and it is irrelevant if the stock price at the time when the 
AMT tax is paid or when the stock is sold is a fraction of this price. 
The ``gains'' at the time of exercise are what count, not real gains in 
a financial sense when the investment is finally sold.
  The application of the AMT at the time of exercise to ISOs is a major 
disincentive for companies to offer ISOs to their employees. The 
purpose of the ISO law when it was enacted by Congress back in 1981 was 
to encourage long-term holdings of the stock. This purpose is defeated 
by the AMT application at the time of exercise. Even if firms could 
educate their employees about the AMT liability, the fact that this tax 
is imposed at the time of exercise on phantom gains would remain a 
major disincentive for them to offer ISOs. The risks are too great that 
the employee will have no real gains with which to pay the tax, that 
employee will have to sell stock immediately at ordinary income tax 
rates to make sure that funds are available to pay the tax when it is 
due, or take the risk of holding the stock.

  My understanding is that the firms that are most likely to grant ISOs 
are those firms that have no ability to use the corporate deduction 
that is available for NSOs. These are small firms with no tax liability 
for which the deduction is simply a tax loss carryforward with no 
current year value. With these firms the ISO held out the possibility 
of the employees receiving capital gains tax treatment of their gains. 
It is particularly sad that it is these firms and these employees which 
are feeling the brunt of the AMT/ISO problem.
  The application of the AMT to ISOs is strange because long-term 
holdings of stock, as required by the ISO law, are classic capital 
gains transactions and we do not apply the AMT to the tax benefit 
conferred by the capital gains tax. Under the AMT only ``tax preference 
items'' enumerated in the AMT are included when the AMT calculation is 
made. The capital gains differential, the difference between the 
ordinary tax rate on income and the lower capital gains rate, is a tax 
benefit but that differential is not included in the AMT. Given all the 
problems we are now seeing with the AMT the capital gains differential 
should not be included as a preference item. But, by an accident of 
history, the AMT is still applied to ISOs. This makes no sense and it 
is an anomaly in the tax code. When the Congress restored the capital 
gains differential, and did not include it as an AMT tax preference 
item, we should have enacted a conforming amendment regarding the AMT 
and ISOs. We didn't, and we should do so now.
  With the AMT applied to ISOs, taxpayers are caught in a Catch-22 
situation. If they hold the stock for the required year, they can 
qualify for capital gains treatment on the eventual sale of the stock. 
But, in doing so they are taking a huge risk that the AMT tax bill will 
exceed the value of the stock when the AMT is paid. If the tax is too 
large, they may have to sell their stock before the capital gains 
holding period has run and pay ordinary income tax rates on any gains. 
This is a form of lottery that serves no public policy.
  The AMT was created to ensure the rich cannot use tax shelters to 
avoid paying their ``fair share.'' Taxpayers are supposed to calculate 
both their regular tax and the AMT bill, then pay whichever is higher. 
The AMT is likely to snare 1.5 million taxpayers this year and nearly 
36 million by 2010. But the case with ISOs is one where the taxpayers 
may never see the ``gains,'' and noneless owe a tax on them. Whatever 
the merits might be for the AMT for taxpayers with real gains, they 
have no bearing on taxpayers who may never see the gains. It is simply 
unfair to impose a tax on gains that exist only on paper. If the 
employee does realize gains, they should and will pay tax on them, but 
only if and when the gains are realized.
  Of course, with the recent huge drop in values for some stocks, many 
entrepreneurs are now being hit with immense AMT tax bills on the paper 
gains on stocks that are now worth a fraction of the price at the time 
of exercise. At a townhall meeting held in California by Representative 
Lofgren and Representative Bob Matsui, Kathy Swartz, a Mountain View 
woman, six months pregnant and soon to sell her ``dream house'' because 
she and her husband Karl owe $2.4 million in AMT, asked, ``How many 
victims do you need before you say it's horrible?'' We are talking 
about taxpayers who in fact owe five- to seven-figure tax bills on 
gains they never realized.
  My bill would change those tax rules so that the AMT no longer 
applies to ISOs and no tax is owed at the time when the entrepreneur 
exercises the option. This change would eliminate the unfair taxation 
of paper gains on ISOs. This would encourage long-term holdings of 
stock, not immediate sale of the stock as a hedge against AMT tax 
liability. It would do nothing to exempt entrepreneurs from paying tax 
on their real gains when they eventually sell the stock.
  My bill would solve this problem going forward. It would not, as 
drafted, provide relief to the taxpayers who already have been hit with 
AMT taxes on phantom gains. There is a bipartisan group in the House 
and Senate focusing on this group of taxpayers. This group has a strong 
claim for relief based on the inherent unfairness of the AMT as applied 
to ISOs. The unfairness of this law leads me to call for reform going 
forward should be remedied for current, as well as future taxpayers.
  Let me be clear about the cost and budget implications of my bill. 
The Joint Tax Committee on Taxation has found that my proposal would 
reduce government tax revenues by $12.412 billion over ten years. I am 
puzzled by this estimate, but there is no way for me to appeal it. The 
JTC does not provide explanations for its estimates, but I would assume 
that this estimate is based on the likelihood that there would be fewer 
tax payments at the time options are exercised as firms move from NSOs 
to ISOs, those employees with ISOs would not be paying the AMT, and 
there will be more employees who hold the stock and pay capital gains 
tax rates. Offsetting this,

[[Page S7199]]

there will be fewer companies taking the deduction for NSOs. The 
revenue loss year-by-year is as follows: --$1.821 billion (2002), --
$1.126 (2003), --$858 (2004), --$825 (2005), --$941 (2006), --$1.106 
(2007), --$1.341 (2009), --$1.620 (2010), and $1.910 (2011). The loss 
during the 2002-2006 period is --$5.494 billion. I will not propose to 
enact my bill unless this sum is financed and will have no impact on 
the Federal budget.
  I am pleased that Rep. Zoe Lofgren (D-CA) has introduced legislation 
on AMT/ISO in the other body (H.R. 1487). Her bill has attracted a 
bipartisan group of cosponsors. I look forward to working with her and 
other Members to remedy this inequity in the tax code and to do so with 
regard to current as well as future taxpayers.
  Let me note that I have proposed in S. 798 to provide a special 
capital gains tax rate, in fact to set a zero tax rate, for stock 
purchased by employees in stock option plans, by investors in Initial 
Public Offerings, and similar purchases of company treasury stock. This 
zero rate would be effective, however, only if the shares are held for 
at least three years, so the AMT gamble would be even more dramatic. 
During the first year of that holding period, the AMT would have to be 
paid and during the remaining period the value of the stock could well 
dive from the exercise price creating an even more invidious trap.
  Kafka ``The Castle'' should remain as magnificent fiction. We have no 
place for taxes on phantom income and paper gains. Our taxpayers should 
be able to communicate effectively with the castle, not be caught in a 
bureaucratic nightmare that makes no sense and serves no policy.
                                 ______