Page 154 - Bruce Ellig - The Complete Guide to Executive Compensation (2007)

140 The Complete Guide to Executive Compensation

Tax rates are prescribed in the IRC for ordinary income (cash), capital gains (property
owned), and an alternative minimum. Ordinary income is taxed at a prescribed rate by
income level, and capital gains (if held for a period qualifying as long term) at a lesser rate.
The alternative minimum tax, which was introduced in the Tax Reform Act of 1969, stipulates
that individuals should pay the greater of regular income tax or the alternative minimum tax
(AMT), which addresses tax preference income (TPI). TPI would include adjusted gross
income plus nontaxed gains on incentive stock option (ISO) exercises, nontaxed income from
tax shelters, and certain otherwise deductible items. The AMT requires planning ahead,
identifying how much TPI can be taken in a year without triggering the AMT. The 1997
Taxpayer Relief Act set the AMT at 26 percent of AMT income up to $175,000, and at 28
percent above that amount. A recap of AMT rates is shown in Table 4-20.

Year Rate

1969 10.0%
1976 15.0%
1986 21.0%
1990 24.0%
1997 28.0%

Table 4-20. Maximum alternative minimum tax rates
The AMT was allegedly established to ensure that taxpayers with significant deductions
and credits paid their fair share (a corporate AMT exists for the same purpose). However, the
elimination of most tax shelters with the 1986 Tax Act and lower tax rates in subsequent years
have trapped more and more middle-income individuals, since the allowable exemptions
(unlike ordinary income) have not been indexed. Individuals living in a high-tax state, with
large families, high medical bills, and exercising a lot of incentive stock options are likely to
be caught in the snare of the AMT. With fewer deductions available to off-set income, and
other items (such as paper gains on the exercise of incentive stock options) being included as
tax preference income (AMT), more and more individuals will be subject to the AMT. If the
taxpayer does not file an AMT liability, the IRS will send a bill for the amount due with inter-
est and penalties added.
After the end of the calendar year, executives receive a W-2 stating the total amount of
ordinary income received for the year. This will include cash and its equivalent for stock. The
latter includes the spread (or gain between market value and exercise price) on the exercise
(purchase) of nonstatutory stock options and the market value of stock given outright. It will
also report the amount of federal income tax and social security tax withheld from such
payments. The executive will also receive a 1099 for dividends and additional forms for other
income taxed as ordinary income.
Capital gains taxation typically is defined as short term and long term. Although it has
varied from time to time, the most common definition has been capital gains on property
held more than 12 months will be taxed at a lower rate than income taxed as short-term
capital gains (i.e., held for 12 months or less). Oh what a difference a day can make!
A history of recent long-term capital gains rates is shown in Table 4-21.