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.

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.