Dec. 12 (Bloomberg) -- Thousands of Internet and technology workers who ended up owing large tax debts from exercising stock options instead of becoming multimillionaires will get some of their money back under legislation Congress passed last week.

The measure, backed by companies such as Intel Corp. and Texas Instruments Inc., was adopted as part of a broader $38 billion tax measure approved by Congress on Dec. 9. It would help end a phenomenon in which workers paid the government almost $1.7 billion in taxes on stock they didn't sell.

These workers owed taxes even if their shares lost value, as many did in the decline of U.S. stock markets from 2000 to 2002. The new law would refund the taxes over five years in many cases.

``We're going to have retirement savings again,'' said Jerry Cornelius, 51, of Dallas. He and his wife, Barbara, mortgaged everything in 2002 to pay a $95,000 alternative minimum tax bill after the value of incentive stock options she took in lieu of a higher salary at Avanex Corp., a Fremont, California-based telecommunications company, tumbled to less than $2 a share from as high as $167 a year earlier. ``We've been living scared,'' he said.

Incentive stock options receive special tax preferences allowing holders to obtain a lower tax rate on their profits.

The average investor owes no taxes on a decline in his or her stock portfolio and can use losses to reduce taxable income. Many people get ordinary stock options, which are usually exercised and sold on the same day and are taxed as ordinary income at rates of up to 35 percent no matter when they are sold.

People like Cornelius faced a different situation because they got incentive options, which, unlike ordinary options, receive the special tax preferences.

Incentive Options

Incentive options once were given only to top company officials. That changed during the Internet boom as start-up companies without enough capital to pay high salaries offered rank-and-file workers the promise of future gains through incentive options.

They would be able to buy company shares at a low price and sell in the open market at a much higher price, a system that made many technology workers multimillionaires in the 1990s. Workers who exercised these types of options and held on to the shares they obtained for at least a year qualified for a low capital gains rate, 20 percent until 2003 and now 15 percent.

The system didn't work for everyone, including Jeff Chou, founder of a group called Reform AMT.

He exercised options in March 2000 that allowed him to buy more than 100,000 shares of Cisco Systems Inc. at 5 cents a share. At the time, Cisco shares were worth about $60 each. Chou decided to wait a year before selling to take advantage of the lower capital gains rate. When the year was up, Cisco shares were trading below $17.

Alternative Minimum Tax

After Chou exercised his options to buy shares, he didn't sell them, and the alternative minimum tax kicked in. The tax applied a 28 percent rate on the difference between his purchase price of 5 cents a share and the price of about $60 at which the shares were trading when he exercised his options. The alternative minimum tax applies even if the stock loses value before it is sold. At $17 a share, the stock price wasn't enough to cover Chou's $1.9 million tax bill.

Once the new measure is signed into law by President George W. Bush, people in situations similar to Chou and the Corneliuses can get their money back over five years.

The provision isn't a total fix. Only households that have paid the tax already and have annual incomes of less than $218,950 will get the rebate, paid in 20 percent annual increments over five years.

Income Threshold

The law doesn't erase the tax liability for those like Chou who have been unable to pay. The income threshold may also make it difficult for some to pay up by cashing in retirement plans because doing so increases taxable income.

Representatives Sam Johnson, a Texas Republican, and Richard Neal, a Massachusetts Democrat, proposed the change in the law, saying it was necessary because those affected have effectively given the U.S. government a $1.7 billion interest-free loan.

``The time has finally come for the federal government to rebate these interest-free loans from working families,'' Johnson said. ``The phantom gains were money my constituents never saw, never spent, and yet they had to pay taxes on. That's a crying shame.''

Convincing Congress

Bob Scharin, senior tax analyst from Thomson Tax & Accounting, a tax products publisher in New York, said the workers had a tough road convincing Congress to provide relief because many would have become multimillionaires had the stock market continued to grow. At the same time, he said, those who did get caught in the trap will have to wait five years to get their money back. ``Those taxpayers are still losing the time value of money,'' he said.

``It's not the full fix or the fair fix yet,'' said Tim Carlson, executive director of the Coalition for Tax Fairness, a Washington lobbying group funded in part by Santa Clara, California-based Intel Corp. and Dallas-based Texas Instruments.

The income threshold, set by the new law, may have the unintended effect of encouraging some higher-income workers to leave their jobs rather than continue to sacrifice a large refund. Someone who has paid $1 million as a result of the incentive stock option and alternative minimum tax trap stands to get as much as $200,000 back a year.

Refund Not Taxed

Because no taxes would be taken out of the $200,000 refund, some people may decide it's better to live on that money than work every day for a salary of more than $218,950, which would be subject to income taxes, and would make them ineligible for the refund, Carlson said.

``Do I continue to work hard and just basically say I'm going to get less of my credits back or none of it?'' Carlson asked. ``Or do I look at maybe I'll take a six month sabbatical every year?''

To contact the reporter on this story: Ryan J. Donmoyer in Washington at rdonmoyer@bloomberg.net.

Last Updated: December 12, 2006 10:00 EST