8 Things to Know About AMT Credit and Incentive Stock Options

Incentive stock options (ISO) and the alternative minimum tax (AMT) go hand in hand (here’s an in-depth guide on their correlation if you’re unfamiliar). If you exercise and hold ISOs in the hopes of enjoying the tax benefits of a qualified disposition (such as its preferential long-term capital gain tax treatment), an adjustment will need to be made to your tax return for the calendar year you exercise and hold that may require you to pay a little or a lot of AMT.

Eventually, however, the hope is to sell your shares and return previously paid AMT as an AMT credit.

Generally speaking, AMT can be complicated, especially if you’ve never had to consider it before. Here are eight facts about AMT credit to help you get more familiar with the role it could play in your financial landscape when you exercise ISOs.

An Introduction to AMT Credit

AMT credit is really only relevant if you owe AMT in the first place. That being said, let’s start by understanding who may be required to pay AMT — as well as exploring its relationship with ISOs.

AMT is  (as it sounds) an alternative tax system that only applies to those who earn above a certain income limit, or those who engage in certain activities like exercising and holding incentive stock options.

To determine whether you will owe any AMT, you need to compare your tentative minimum tax (TMT) to your regular tax liability. You will generally be required to pay the higher of the two, which in an “ordinary” tax year is often the regular tax system. However, in years where you exercise and hold ISOs, your TMT may exceed your regular tax, thus resulting in some AMT liability.

This is because the bargain element, or difference between the strike price of your ISO and the FMV at exercise, is an adjustment on Form 6251 and can increase your TMT above your regular tax, resulting in AMT liability.

What Is AMT Credit?

Assuming you’ve paid AMT as a result of exercising your ISOs, those tax dollars can be returned to you in future tax years in the form of AMT credit.

Calculating your AMT credit amount is similar to how you calculate your AMT liability, as your AMT credit will be based on the difference between your regular tax and TMT calculations. Basically, if you paid AMT in a previous tax year and the TMT is lower than your regular tax in a following tax year, the difference between the two can result in an AMT credit.

For the rest of this article, let’s assume you earn $300,000 and your tax status is married filed jointly.

Now, lets also assume that you have previously paid $50,000 of AMT from the exercise and hold of ISOs.

While projecting your upcoming tax return, you determine that your regular tax is $51,000 and your tentative minimum is $43,000. In this instance, your regular tax calculation is higher, so that’s what you’ll be required to pay.

Because you have a $50,000 AMT carryforward, however, you are eligible for an AMT credit of $8,000, which is the difference between regular tax ($51,000) and TMT ($43,000). Thus, the actual tax due is $43,000.

After you’ve used that initial $8,000 in AMT credit, the remaining $42,000 of AMT credit will be carried forward to future tax years.

Now, let’s get into the eight things taxpayers need to know about AMT credit.

#1: You Can Get AMT Credit in Years You Don’t Sell ISOs.

With ISOs, you generally only pay AMT in a year you exercise and hold. You do not, however, have to sell qualified ISO shares to initiate the return of the credit. In practice, you’ll likely return some AMT credit each year even if you do not sell ISOs.

As we mentioned above, how much AMT credit you return each year is limited by the spread between your regular income tax and tentative minimum tax calculations.  Different incomes can and will impact how much your AMT credit will be returned. For lower income persons, this may result in a smaller credit for many years. For high-income taxpayers, it’s possible you may receive a significant credit even in years you do not sell qualified ISO shares.

#2: Selling Qualified ISOs May Lead to a Big AMT Credit.

If you’ve exercised and held ISOs and incurred AMT, you’ve likely done so for a few reasons:

• You’ll sell later as a long-term capital asset (a qualified disposition), and
• You plan to sell your shares at a higher price than when you exercised.

Here’s an important consideration and benefit of a qualified ISO sale that tends to fly under the radar: Often, you’re more likely to return AMT credit in the year of sale.

Continuing our example above, we know that in a do-nothing scenario (not selling qualified ISOs) the total AMT credit is around $8,000.

With that number in mind, we can compare this to a second scenario where we chose to sell qualified ISOs. Specifically, we assume the following:

• Total Capital Gain: $200,000
• AMT Capital Gain: $25,000

(Note: AMT capital gain (or loss), in this example, is calculated as the difference between the final sale price of the stock and the FMV of the ISO stock at exercise).

When incorporating these figures into the tax planning, we calculate an AMT credit of around $34,000.

Logically, the AMT credit makes sense. If the total capital gain is $200,000, and we assume a 15% capital gains tax rate, the total tax due would be $35,000. Effectively, the AMT credit is offsetting the capital gain tax due on the sale itself (you paid for it at exercise via AMT).

(Note: The numbers do not always line up so close, but this example is helpful to illustrate what is happening with AMT at exercise and AMT credit at sale).

#3: You May Not Get the Full Amount of AMT Paid in the Year You Sell Your Stock.

Following the example above, you’ll notice you paid $50,000 in AMT at exercise and only returned $34,500 of credit at sale. In practice, not getting all your AMT back in a single year is not uncommon. Particularly in situations with a significant AMT, you do not always return the full amount as a credit in the year of sale.

Unused AMT can be carried-forward indefinitely while you are alive and can trickle back to you over many years (as we’ve already discussed).

#4: The Qualified ISO Grant You Sell May Impact How Much AMT Credit You Can Use in a Given Year.

So far, we have illustrated ISO and AMT credit with a single grant. In practice, however, you may find yourself with multiple ISO grants and multiple exercise dates. To illustrate, your ISOs may look something like the table below.

In this example, you’ll see at the bottom of the table that the option grant with the higher FMV at exercise (or the largest spread between the strike price and FMV at exercise) results in the highest AMT credit.

All else equal, shares with the highest spread between strike price and FMV at exercise led to the highest AMT paid at exercise. They also have the highest spread between regular cost basis and AMT cost basis, which directly impacts the calculation for AMT credit.

#5: Qualified ISO Shares Sold at a Loss May Slow AMT Credit.

While everyone hopes that the stock price will increase after exercising, the reality is that not all stocks will. Some will go down, leaving the resulting shareholder with an AMT loss position.

AMT loss occurs when the prevailing stock price is below the price you exercised. For example, say you exercised and held when the price was $40 per share, and now the price has dropped to $30 a share.

For obvious reasons, the stock price going down is not desirable. For ISOs, in particular, AMT loss shares may create a second negative consequence — they may impede your ability to return AMT credit.

When you sell qualified ISO shares, you may be able to make a negative adjustment on your tax return and leverage some AMT credit. Unfortunately, this negative adjustment may be impacted since AMT loss shares are capped at $3,000 per year, just as regular capital gains are.

To illustrate, we have a chart below that assumes three different AMT loss scenarios, ranging from small to large, and the corresponding AMT credit.

As you can see, in the scenario at the top of the chart with a greater AMT loss (-$150,000), the AMT credit is meaningfully reduced to around $12,200 compared to scenarios with a smaller AMT toward the bottom of the chart.

This occurs because the actual negative adjustment that helps create room for AMT credit is limited by the difference between AMT capital gains (or loss, which is capped at -$3,000) minus the regular capital gain. The remaining AMT capital loss can be carried forward to future years and used against AMT capital gain.

Notably, in a scenario with significant AMT paid at exercise and meaningful capital loss at sale, you may find yourself with significant AMT credit carryforward with little ability to return it back.

#6: Other Capital Gains and Losses (Not Associated With Subject Stock) Matters Too.

The final adjustment on Form 6251 for figuring the AMT credit is based on the difference between regular capital gain and AMT capital gain for all investments on your tax return, not just the sale of ISOs. Other activity, such as capital gains and capital losses from non-company-stock accounts, matter as well.

Using the prior example in item 4, let’s assume you have a regular gain of $200,000 and an AMT gain of $25,000. In this example, the adjustment is -$175,000 ($25,000 – $200,000), leading to a ~$33,000 AMT credit.

Let’s add a $75,000 tax loss harvest to the planning, assuming we are offsetting gains and lowering the tax due. Now we have the following:

• Regular Capital Gain:
  • $200,000 (from ISO) + -$75,000 (from TLH) = $125,000
• AMT Capital Gain:
  • $25,000 (from ISO) + -$75,000 (from TLH) = -$50,000
• AMT Capital Gain – Regular Capital Gain:
  • -$3,000 (which we discussed in item 5) – $125,000 = -$128,000

In the scenario with no tax loss harvesting, the negative adjustment for figuring the AMT credit is $175,000. In the scenario with tax loss harvesting, it is reduced to $128,000.  The impact of a reduction in a negative adjustment may result in a reduced AMT credit.

#7: High Earned Income Years Can Be a Good Time to Get AMT Credit.

High earned income years can help return AMT credit even without qualified sales. For the same reason, high-income years can increase the AMT crossover, and the same logic applies to the AMT credit.

High-earned income years may result in a larger spread between the regular tax and TMT. Assuming you have AMT carryforward and you have a high earned income, you may be able to return significant credit in that year.

For example, if we increase earned income in our example from $300,000 to $1.1mm, the entire $50,000 of AMT credit is returned, even with no qualified sale.

#8: You May Need to Decide Between AMT Credit or Exercising and Holding Shares.

If you have AMT carryforward and unexercised ISOs, you may need to choose between returning AMT credit OR exercising and holding ISOs.

Continuing our example from the high-earned income year, we have determined that if you do nothing, you can return the $50,000 of AMT credit. However, what if you also have unexercised ISOs with a $250,000 bargain element?

If exercised and held, an adjustment is made on Form 6251 for figuring AMT and, ultimately, AMT credit. We find that instead of returning an AMT credit of $50,000, you now owe $22,283 in AMT, a swing of ~$72,000.

When planning, a prudent conversation with an advisor might consider what makes more sense from a cashflow, tax planning, and investment risk standpoint. One of many considerations could be to alternate years when you exercise and hold (paying AMT) and sell qualified shares (returning AMT credit).

Have More Questions on AMT Credit?

Determining and planning for AMT and AMT credit can be complicated. While the items shared above are meant to introduce important concepts about AMT credit, you may have some more specific questions and concerns relating to your ISOs and tax liability.

We encourage you to reach out to an experienced financial professional, like the advisors at Zajac Group, to learn more about how the AMT credit may be able to help you control your tax bill this year. Contact us to get started today.

This material is intended for informational/educational purposes only and should not be construed as investment, tax, or legal advice, a solicitation, or a recommendation to buy or sell any security or investment product. The information contained herein is taken from sources believed to be reliable, however accuracy or completeness cannot be guaranteed. Please contact your financial, tax, and legal professionals for more information specific to your situation.