Incentive Stock Options and The Alternative Minimum Tax

If you have incentive stock options, you’ve likely heard the term alternative minimum tax, or AMT. But what is the AMT, and how is it calculated?

It’s a type of income tax, but very different than what you may be used to paying.

Typically, the calculation of your total income tax due is subject to the rules and regulations of the regular tax law. This regular tax is the commonly-discussed water cooler conversation of which most taxpayers are aware.

What most taxpayers are not aware of is a second calculation, the tentative minimum tax, that also occurs every year.

Alternative Minimum Tax and The Impact of Higher Tentative Minimum Tax

As a taxpayer, you generally pay the higher of the two tax calculations: regular tax or tentative minimum tax. As long as the tentative minimum tax calculation is lower than the regular tax calculation, you don’t owe AMT.

But if the tentative minimum tax is higher than the regular tax, you’re subject to AMT. AMT is the difference between the tentative minimum and regular tax when the tentative minimum is the higher of the two.

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Exercising and holding incentive stock options is one thing that can increase your tentative minimum tax calculation. In the calendar year you exercise incentive stock options, the spread between the exercise price and the fair market value at exercise (multiplied by the number of options exercised), is included in your income for calculating your tentative minimum tax.

This is the bargain element, and it’s not included when calculating your regular tax. The larger the bargain element, the more you may be subject to a significant AMT bill.

How Do You Calculate Alternative Minimum Tax?

The calculation of the tentative minimum tax is based on a nearly flat tax rate of 26% and 28% percent. For 2023, the first $220,700 of your income is taxed at 26% and any amount in excess of $197,900 is taxed at 28% for married filing joint.

The AMT rates at which income is taxed differently than regular tax law. How you calculate what counts as taxable income is different, too.

For example, the bargain element isn’t included when calculating regular taxable income, it is included when determining whether or not you owe AMT.

Why Does the AMT Matter for Your Exercise of Incentive Stock Options?

The larger the value of the bargain element, the greater the potential for AMT. And of course, more AMT means a larger tax bill for you overall. Where will you get the cash to pay that bill?

This question is why AMT is so important to consider before you start exercising your incentive stock options.

First, let’s understand how much cash you may need to foot your tax bill.

Say you have 10,000 incentive stock options with an exercise price of $1 per share and a fair market value at exercise of $50 per share. You decide to exercise and hold the ISOs. How much tax do you owe?

Here’s how this example breaks down:

• Cash needed to buy the shares at exercise: $10,000
  • This is calculated by multiplying the number of options exercised by the exercise price per share ($1 x 10,000)
• Cash needed to pay the tax at tax time (assuming a 28% flat AMT): $137,200
  • This is calculated by multiplying the AMT rate by the fair market value at exercise less the exercise price X the number of shares: 28% x [($50 – $1) x Shares]

Most people don’t keep an extra $137,200 in cash lying around, freely available to spend on taxes. For many, paying this tax bill may not even be an option.

If you don’t have such an amount, you may be forced into other exercise strategies that create the required cash to cover both the exercise cost and the taxes that trigger.

And even if you do have that kind of cash available, you need to ask yourself: Do you want to use your cash to buy and hold shares?

If you do, you may be doubling down on your investment in the company stock by taking otherwise non-company stock assets and making them company stock. There are a lot of variables and factors to think through before taking any actions with your options.

This is why it’s important to have a comprehensive financial plan in place that takes both your finances and your potential taxes into account.

A Pre-Payment of Tax and the AMT Credit

One way to think about the AMT is to consider it a method the IRS uses to get you to pre-pay any potential tax you owe. “Squaring up” with the IRS on your pre-payment of AMT may occur when the exercised and held shares are subsequently sold.

Often, shares are sold in a qualifying disposition. A qualifying disposition occurs when the final sale of shares occurs at least 2 years from the grant date and at least 1 year from the exercise date.

Upon the final sale of shares (and assuming they are qualified), the total value from the exercise price of the ISO to the final sale price is subject to preferential long-term capital gains treatment. If we assume that long-term capital gains rates are 15%, it would be reasonable to assume the difference between the 28% AMT prepayment and 15% long-term capital gains may be an overpayment of income tax, particularly relating to the spread at exercise.

Remember our example above where you ended up owing $137,200 in AMT in the year the options were exercised? This tax calculation was based on a 28% AMT rate. If we assume these same shares are sold as a qualifying disposition (at the same price as at exercise) and subject to a tax rate of 15%, you’d owe $73,500.

Enter the AMT credit. In the year you sell the qualified ISO shares, you may receive a negative adjustment to the tentative minimum tax which might mean some or all of the previously paid AMT will be credited back.  For example, you may owe $73,500 long-term capital gains tax and also receive a $137,200 AMT credit, for a net tax of -$63,700 (potentially a refund).

Unfortunately, the math behind how much you recover via the AMT credit is not as simple as advertised above. In fact, due to very complicated tax calculations, you may not be able to fully recover 100% of the AMT you pay (or it may take a very long time to do so), even if you perform a qualified disposition for all your shares.

What’s Next with Incentive Stock Options and the AMT

Understanding and interpreting the full scope of the AMT as it relates to incentive stock options is complicated. However, you can leave this article with a few key items in mind:

• You may owe AMT in the calendar year you exercise your stock options.
• The amount of AMT you’ll pay is related to the spread between the grant price and the exercise price of your stock options, multiplied by the number of shares you exercise.
• You may be able to get some of your AMT back in future years. But you may not get all of it back, or get it back as quickly as you hope.

Armed with this information, you can begin to ask questions regarding how you can avoid and/or limit AMT and how to implement incentive stock option exercise strategies.

Taking things one step further, you can complete a personalized tax projection with various assumptions for tax and growth rates can help you evaluate how much AMT you may pay under different strategies over the course of many years.

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.