How to Exercise Incentive Stock Options to the AMT Crossover Point

Finding the best time and best strategy to exercise incentive stock options is difficult. Competing considerations on income tax, investment planning, and financial planning make it difficult to address the best time to exercise incentive stock options (ISOs) with a blanket answer.

Some strategies suggest that exercising early may be a good idea, because this is when the impact from the alternative minimum tax, or AMT, may be lowest. Others suggest it’s best to exercise as late as you can. Waiting provides more clarity as to the final value of the stock options, and your incentive stock options become a use it (exercise) or lose it (the stock option expires) situation.

Exercising early or exercising late aren’t your only two options. Instead, you might want to consider an exercise and hold up the AMT crossover point, or the point where you tentative minimum tax equals your regular tax. Or more simply, the point where you can exercise and hold ISO and not incur AMT.

In a limited sense,  an exercise up to the AMT crossover point strategy might provide you with a way to “have your cake and eat it too.”

With good planning, you can exercise a specific number of ISOs without incurring any AMT. Once exercised, the held shares of stock begin the holding period to obtain a qualifying disposition.

Unfortunately, the details of this implementing an exercise up to the AMT crossover point may get a little confusing. Let’s walk through them together.

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Changes in the Way Alternative Minimum Tax is Calculated Due to the 2017 Jobs Tax Act

The exercise to the AMT crossover strategy has always been an option if you have incentive stock options and good tax planning skills. The 2017 Jobs Tax Act expanded that opportunity because it changed the way AMT will be calculated in 2018 and beyond.

The 2017 Jobs Tax Act made changes to increase exemptions and increase when phaseouts of said exemptions occur when calculating AMT. This is all a fancy way of saying that it is likely less people will be subject to AMT in 2018 and beyond.

Moving into 2019 and 2020, key figures for the exemption and phaseout are as follows:

For those with ISOs, a byproduct of the 2017 Jobs Tax Act may have created an opportunity for a larger AMT free exercise of incentive stock options than previously eligible.

Before we dig into a hypothetical example, let’s recap what we should already know about ISOs and the AMT.

Incentive Stock Options and the AMT

When you exercise and hold incentive stock options, you likely do so with the hope of obtaining a qualifying disposition. A qualifying disposition is one when the final sale of the stock occurs at least 2 years from the grant of the incentive stock option and one year from the exercise date of the option.

The result of a qualifying disposition is that the value from the strike price of the ISO to the final sales price is treated as a long-term capital gain (assuming there is a gain in value).

What complicates this strategy is the AMT. AMT is based on a secondary tax calculation that occurs every year you file a tax return known as the tentative minimum tax.

As a taxpayer, you generally pay the higher of the regular tax calculation and the tentative minimum tax. AMT is what you pay when the tentative minimum tax is higher than the regular tax.

When you exercise and hold incentive stock options, the bargain element (the difference between the strike price and the fair market value at exercise, multiplied by the number of options exercised) is included in the calculation of the tentative minimum tax. That potentially makes the tentative minimum tax the higher of the two calculations, leaving you on the hook for paying AMT.

To effectively exercise and hold ISO to the AMT crossover point is the spread between the regular tax and tentative minimum tax. The smaller the spread between the two, the smaller the opportunity. The greater the spread, the greater the opportunity.

All else being equal, the 2017 Jobs Tax Act increased the spread between the two. This means you can likely exercise more of the bargain element than previously allowed, which leads to a greater planning opportunity.

AMT Crossover Point Example when Exercising Incentive Stock Options

Using a hypothetical example, we can illustrate how to exercise and hold ISOs up to the AMT crossover point.

We will use a simple tax return with a few assumptions for our illustration:

1. Our taxpayers are married couple and both spouses are 55; no kids
2. They file as Married Filing Jointly on their tax returns
3. They earn $250,000 of gross annual income
4. They take the standard deduction

A Hypothetical Tax Analysis

When we plug the above information into a hypothetical tax return, we can calculate two key numbers: regular tax and the tentative minimum tax.

Simplifying a return, we see the following:

As you can see, the regular tax is $45,200 and the tentative minimum tax is $35,958.  As the regular tax is the higher of the two calculations, this household will be required to pay $45,200 in tax.

When planning an AMT crossover strategy, you want to review the spread between the two calculations. In this scenario, the spread is $9,042.

At this point, we need to ask:

1. How many incentive stock options can you exercise and hold and have the regular tax calculation be the higher of the two?
2. How much of bargain element (the difference between the strike price and the FMV at exercise, multiplied by the number of shares exercised) can you incur until you reach the AMT crossover point?

A simplified calculation is dividing the spread by 26% (26% is being used as our AMT tax rate)

($45,200 – $35,958) / 0.26 = $34,777

In this simple calculation, these taxpayers could exercise and hold $34,777 of the bargain element and still pay no AMT.

If we wanted to be exact in our calculation, it would be necessary to go back to actual tax software to project the return.  If your tentative minimum tax is higher than your regular tax, you may be able to modify by lowering the bargain element.  Alternatively, if your tentative minimum is below the regular tax, you may be able to capture more bargain element.

Applying These Examples to Your Incentive Stock Option Grants

Once you know the amount of the bargain element you can capture, you can circle back to your incentive stock option grants to determine how many options you can exercise. Let’s assume you have the following grants:

As you can see from the line on the right, if you exercised all of the grants above, you incur $440,000 from the bargain element. But the goal is to exercise only enough to reach the crossover point.

To do so, we need to calculate how many shares you could exercise to reach $34,777 worth of the bargain element for 2018.

If we assume that you exercise shares from Grant 1, the math is as follows:

“Shares to Exercise” X (FMV at Exercise – Strike Price) = Bargain Element

“Shares to Exercise” X ($25 – $1) = $34,777

“Shares to Exercise” = 1,449 (rounded down)

If we assume that you exercise shares from Grant 2, the math is as follows:

“Shares to Exercise” X ($25 – $5) = $34,777

“Shares to Exercise” = 1,738 (rounded down)

While you can exercise more shares if you are doing exercise grant 2, you may also want to pay attention to the cash flow required to do so.  When you exercise your ISOs, you will need to pay for the shares.  The cost of each exercise is:

Shares Exercised X Grant Price

Grant 1 Cost = 1,449 X $1 = $1,449

Grant 2 Cost = 1,738 X 5 = $8,690

In this example, the cost of Grant two is materially higher than the cost of grant 1.  A full decision about AMT crossover should include the cost of the AMT as well as the cost of exercising and holding said shares.

The Benefits of The AMT Crossover Point Strategy

If you followed the details of the above analysis, you might notice you don’t actually save income tax in the year you exercise up to the AMT crossover point. So what, if any, value does this complicated strategy have?

The first benefit is a future tax savings opportunity. If you implement this strategy correctly, you will not pay AMT (or you will pay limited AMT) on the exercised ISOs. If you do not implement this strategy, it is reasonable to assume that you’ll exercise your ISOs in a year when you are subject to AMT.

For example, in lieu of exercising some options each year, you might exercise an entire grant in a single year. If we assume this is true, and we assume that the ISOs will be subject to AMT in the future, they will be taxed at the requisite AMT rate in that year.

If we compare exercising ISOs at zero cost today versus 28% later, we have a clear winner.  The tax savings opportunity is 28% in opportunity cost.

(To be fair, some or all of the 28% AMT you pay may come back to you as an AMT credit in future tax years. In this sense, it’s not a total 28% savings. On the other hand, AMT also may cause a cash call need that you could avoid with the AMT crossover strategy).

The second benefit of this strategy is that it starts the holding period for a qualifying disposition of some of your shares. This means that after 1 year from exercise, you will have a portion of your shares that are eligible to be solid in a preferential tax treatment via qualifying disposition.  This creates liquidity that you may not have otherwise had.

For example, imagine that you need $X amount of dollars but did not follow the above strategy. To get that money, you’d likely need to do a disqualifying disposition of ISOs, meaning a higher tax bill as you wouldn’t meet the requisite holding periods (assuming you cannot go somewhere else for the money).

A third benefit is the cumulative effect of this annual exercise strategy. In our example, you can exercise $34,777 without incurring AMT. If you do this year over year, for 10 straight years, you could exercise and hold nearly $350,000.

Ultimately, every tax situation is different and you should run a detailed tax calculation on your own (or with the help of an advisor). But the opportunity is one that should be explored if you hold incentive stock.

Summing It All Up

The exercise up to the AMT crossover point is nothing new. What is new is the changing tax laws that may create additional room to exercise and hold more incentive stock options each year. As the opportunity to exercise and hold gets bigger, so does the opportunity to take advantage of this with good planning.

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. Hypothetical examples contained herein are for illustrative purposes only and do not reflect, nor attempt to predict, actual results of any investment. 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. Investments are subject to risk, including the loss of principal. Because investment return and principal value fluctuate, shares may be worth more or less than their original value. Some investments are not suitable for all investors, and there is no guarantee that any investing goal will be met. Past performance is no guarantee of future results. Talk to your financial advisor before making any investing decisions.