Many people are so concerned about taxes that they adopt investment strategies that actually lose more than they save in taxes. Decades ago limited partnerships involving real estate, oil and gas or equipment leasing were purchased by high income individuals as tax shelters. Many ended up losing some or all of their investment.
But there’s another common strategy involving stock options that have hurt some high net worth individuals.
An advisor tells the story of a client in the late ’90s who sought his help to minimize taxes on incentive stock options that had amassed enormous built-in gains.
The individual worked for a dot-com company and had stock options with a huge gain and wanted to minimize taxes. One tongue-in-cheek answer is to wait until the stock crashes, eliminating the tax problem. The strategy in case of a “hot” stock that can come down as fast as it goes up is to do a simultaneous exercise and sale, pay the tax at ordinary income rates and be thankful for the windfall.
But many people are reluctant to pay the tax and will choose to exercise their options and then hold the stock for a year and a day before selling it. This allows them to pay tax at the lower long-term capital gains rate rather than the higher short-tem rate.
But here’s the problem with this strategy. If the stock collapses before the year is up all their gains can be wiped out. But it gets worse. By exercising their options the techies became subject to the AMT (alternative minimum tax) and received a huge tax bill at the 28% rate.
As an example, if the techie exercised options worth $1 million they would owe $280,000 in taxes just for exercising. If the stock went to zero, they could claim a loss, but still have to pay the tax.
The lesson for everyone is: be aware ahead of time of the potential consequences of tax avoidance strategies. If they can lead to bad results, pay the tax.