Tuesday, April 14, 2009

Phantom Income Strikes

Investment firm Thoma Bravo is buying my former employer, Entrust Inc. You’d think that since I haven’t worked there for nearly 8 years, I wouldn’t have strong feeling about this takeover. Unfortunately, due to bizarre tax laws this is going to cost me a 6-figure tax bill for 2009!

You see, back in the heady days of the late 90s, most people working in high tech got stock options. These options give the holder the right to buy shares at a fixed price. When the stock goes up, the holder of the options gets to buy the shares at the lower price and make money on the difference.

Unfortunately for me (and many others), I bought shares, but hung on to the stock. So, I got shares at a cheap price when they were trading ridiculously high, but then sat on my hands and watched the share price make a long, sad descent.

Now, I’m being forced to sell my shares to Thoma Bravo for a price lower than I paid for them. But, that’s the way it goes with stock ownership. I bought the shares for $2.13 each and am being forced to sell them for $1.85, a modest loss.

The twist here is that the government wants me to pay taxes on the value of the shares back when I bought them (over $20 each). So, I bought the shares cheap, sold them even cheaper, and I get to pay taxes on the ridiculously high price (that I never actually received).

Let’s call the value of all the shares at the time I received them “huge number”. I prefer not to disclose the actual amount, but let’s just say that if I had this phantom amount in cash, I could buy a nice house and several cars. But, remember this huge number doesn’t exist as real cash and never really did.

Fortunately, this huge number is taxed at the same rate as capital gains; so, I only have to include half of it in my income. I figure that I will have to pay about 22% of the huge number in added income taxes. The sale of the shares will get me only 9% of the huge number. So, next April I’ll have to come up with about 13% of the huge number. Ouch.

A while back employees of SDL Optics (later acquired by JDS Uniphase) got caught with this problem. Most of these people weren’t high rollers. They worked for modest income, bought into a company savings plan, and were surprised with a tax bill amounting to a few years pay. For some reason the government decided to forgive their debts, but not the debts of many other people in the same situation.

In case this all sounds crazy enough that you’re sure I’m insane, here is an article describing the problem and what was done for the SDL Optics employees, and here is the remission order for 3 of those employees.

This whole business could be fixed if the government allowed stock option gains to be offset against capital losses. After all, they’re both taxed at the same rate. Instead, I’ll pay a lot up front and get a huge capital loss to carry forward to eliminate future capital gains.

In theory this just changes the timing of when people pay their taxes. In practice, this tax law has devastated some people’s finances so badly that they have little hope of owning enough stock to ever earn enough capital gains to make use of the huge capital loss.

So, the only case where the current tax law makes a meaningful difference is when it ruins someone. I can’t understand why the government thinks it makes sense to wipe someone out with a tax bill far exceeding any money they received.

No doubt some people think this is a problem for wealthy high rollers who partied hardest during the tech boom. The wealthy people are the ones who will get their money back anyway using the capital losses in the future. It’s the smaller guys who are permanently harmed.

15 comments:

  1. I sympathize. A very raw deal.

    But why did you take ownership of the shares if you had no intention of selling?

    ReplyDelete
  2. Mark: I did intend to sell, but not right away. The service made available by the company involved committing to a sale a day or two in advance. Even then, the firm hired to do the trades sometime 'lost' the faxed instructions. I acquired the shares intending to sell them through my own broker on my terms. In fact, I did sell some of the shares. But, time passed and a significant block of shares still remain.

    ReplyDelete
  3. Yikes. So you're basically prepaying your capital gains tax for the next few decades. This policy sucks.

    ReplyDelete
  4. Patrick: That's right (for me, anyway). Some of my former colleagues are unlikely to ever generate enough capital gains to get their taxes back.

    ReplyDelete
  5. I'm a bit confused still, even after reading the article.

    So you're taxed based on the difference of price when you acquired the stock. Got it.

    But you say that's taxed as capital gains. The article implies it's taxed as income, which is why the capital loss on the forced sale can't be applied against it. So which is it?

    Using some made up numbers of a $20 value and $2 price, that's $18 in gains. If it's now $1.80, is that a $0.20 capital loss or $18.20? Obviously, if it's a $0.20 loss, then it doesn't come close to matching against the gains, if it can even be applied against it.

    ReplyDelete
  6. Astin: The option gains are taxed at the same rate as capital gains, but they are considered to be a different category. You can think of it as half the option gains are regular income. Based on your numbers, the employment gain is $18/share (of which only $9 is taxable), and the capital loss is $18.20/share. Incredibly, these two can't be traded off against each other to give a net capital loss of $0.20/share. So, I pay a huge tax bill now and will have a huge capital loss to carry forward.

    ReplyDelete
  7. I am astounded someone bought Entrust but I guess the sun shines on an ugly dog's ass once in a while, too bad it will give you a bad burn.

    Is the sale final ?

    ReplyDelete
  8. It's really not a fair tax, since it doesn't allow for the complexities of real life. Your response to Astin highlights the intricacies.

    I agree with you that the capital losses are unlikely to be used by a lot of people. Either, as you mention, people will have a greatly impaired capital base, or they will just not be inclined to make investments likely to qualify for future capital gains. Perhaps they prefer bonds and GICs, or perhaps they have almost all of their investments in RSPs. Raw deal, and I guess it's a result of the tax creators not envisioning such a diminution of stock prices following exercise of the stock options.

    ReplyDelete
  9. Big Cajun Man: I'm not surprised that Entrust wanted to be bought. I had hoped that it would take at least another year. As far as I know, the deal isn't final yet.

    Gene: I can't decide if the creators of this tax law didn't see this coming or if they thought that stock option-toting high rollers would somehow be getting away with something if they could cancel option gains with capital losses. Either way, though, there doesn't seem to be any political will to fix this problem.

    ReplyDelete
  10. What bothers me about the JDS employees is the preferential treatment they receive that is not available to others. Tax policy should be applied uniformly, not selectively.

    ReplyDelete
  11. CC: I take the relief for JDS employees as an admission that the tax policy is broken. To then apply it selectively is outrageous.

    ReplyDelete
  12. CFET is working to fix this tax nightmare! Please sign our petition.

    http://cfet.ca/

    ReplyDelete
  13. I remember the idiotic method of faxing in your orders a few days before and hoping it did not get lost. When the stock was fluxuating $5/day, you really stood a chance of losing a lot of money! I also remember coming back from vacation to find that the stock had lost almost half it's value the week I was gone. I really should have sold then at $75 :-)

    ReplyDelete
  14. CFET: I've already signed, and I encourage others who think this situation is ridiculous to sign as well!

    RP: I remember following up each fax with a phone call the next morning to confirm that the fax was lost and had to be sent again. I never came to a conclusion about whether I thought this was simple incompetence or whether the company was trying to discourage sales of the stock.

    ReplyDelete
  15. http://www.jamiegolombek.com/articledetail.php?article_id=868

    ReplyDelete