If you have incentive stock options, you may be familiar with the alternative minimum tax (AMT), and potentially the alternative minimum tax credit. The alternative minimum tax is a complicating factor that may rear its head in a year that you exercise and hold incentive stock options.
A key feature of incentive stock options is that, if you do a qualifying disposition, you may be able to claim long-term capital gains rates on the gain between the exercise price of the incentive stock option to the final sales price. If you do a disqualifying disposition, you may be taxed at less favorable ordinary income (or short-term capital gain) rates. Because of this potential tax advantage, it may make sense to understand the risk-reward trade-off.
Pursuing this better tax treatment, however, may create a bigger tax bill than you expected, thanks to the alternative minimum tax. You might owe some amount in AMT for the calendar year you exercise and hold your incentive stock option shares.
When you sell your incentive stock options shares as a qualifying disposition, you will likely be taxed again on the sale of the stock. This tax can make it feel like you’re being taxed twice on the same income.
This is where the alternative minimum tax credit comes into play. The AMT credit is in place to attempt to solve this problem so that you and the IRS can square up fairly on your tax bill.
The AMT credit also creates a tax planning opportunity.
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When you sell your incentive stock option shares as a qualifying disposition, you may want to keep in mind that not all shares are created equal — or at least, they don’t all have the same AMT basis. The AMT basis equals the number of shares exercised times the fair market value at exercise.
Here’s why the AMT basis matters and how it creates an opportunity to accelerate tax credits.
Understanding What Drives the Alternative Minimum Tax
When you exercise and hold incentive stock options, you may be subject to the alternative minimum tax (AMT). This is because the difference between the exercise price of your options and the fair market value at exercise, known as the bargain element, is a tax preference item for figuring the alternative minimum tax.
A significant bargain element can make a big impact on how much you might owe in AMT. In fact, the larger the bargain element, the larger the potential taxes due. This is why it’s so important to choose the right stock options to sell to accelerate the amount of AMT credit that may come back to you — but more on that in a moment.
Owing taxes may create a tricky problem if you want to exercise and hold your incentive stock options. It’s a cash flow issue, and the question is whether or not you have enough cash on hand to pay the alternative minimum tax due.
Cash flow complications may be further complicated by the fact that if you exercise and hold incentive stock options with a cash exercise, you compound your cash outlay: you need to pay for the options with cash as well as have cash available to pay the AMT due.
(This potential negative cash flow in the year of exercise is why many people with incentive stock options may choose a cashless exercise instead of a cash exercise.)
How much in AMT will you owe, you ask? A very simplified way to estimate is by assuming a 28% tax rate on your bargain element.
Using a hypothetical example, as an illustration, we can calculate the potential tax impact of exercising and holding incentive stock options. Let’s assume the following:
| Exercise Price | $5.00 |
| Fair Market Value at Exercise | $50.00 |
| Options Exercised | 10,000 |
| Bargain Element at Exercise | $450,000 |
| Tax Due (at 28%) | $126,000 |
If you exercise and hold in the example above, you could owe $126,000 in alternative minimum tax for the year you exercise.
The Alternative Minimum Tax Credit
It’s fair to ask why you’d want to incur AMT on incentive stock options when you can simply perform a disqualifying disposition and have the gain between the exercise price and fair market value at exercise and sale be taxed as ordinary income.
The answer is tied to tax. If you exercise and hold your shares until they qualify as a qualified disposition, then the entire gain, from exercise price to final sale price, will be taxed at long-term capital gains rates — which are more favorable than ordinary income rates.
And on top of that benefit, you can get some or all of the AMT paid back to you as a credit.
In an overly simplified example, if you originally paid AMT at 28% and long-term capital gains rates are 15% when you perform a qualified disposition, you “overpaid” taxes by 13%, potentially leaving you eligible to get the overpayment of tax back. This “spread” is a potential benefit of a qualified sale.
Continuing the example above, if we assume the price of the stock remained constant for one year and the shares were sold as a qualified disposition, we can calculate you owe $67,500 in taxes (assuming a long-term capital gains rate):
| Exercise Price | $10.00 |
| Fair Market Value at Exercise | $50.00 |
| Fair Market Value Final Sale | $50.00 |
| Shares | 10,000 |
| Long-Term Capital Gain | $450,000 |
| Tax Due (at 15%) | $67,500 |
Remember, you paid $126,000 in AMT when you exercised your incentive stock options. Once you sell these exercised options in a qualifying disposition, you get to adjust your tax return for the sale.
Since you actually owed $67,000 in this example but already paid $126,000, then we can suggest you may have “overpaid” by $58,500 ($126,000 minus $67,5000).
How to Maximize the Alternative Minimum Tax Credit by Exercising the “Right” Tranche
Now that we have a simple understanding of the taxation of incentive stock options, we can begin to use this understanding to consider AMT credits—specifically as it pertains to the final liquidation of incentive stock option shares.
From a practical standpoint, it’s not uncommon for an employee to have several tranches of incentive stock options. These tranches come from incentive stock options that were exercised at different points in time.
Often, these tranches have different exercise prices, different fair market values at exercise prices, and different spreads between the two. These different prices may create a tax planning opportunity.
Let’s explore a hypothetical example. (assuming all transactions will meet the standard for a qualifying disposition):
| Tranche | Exercise Price | FMV at Exercise | Final Sale Price | Bargain Element | AMT Tax (@28%) | LTCG (@15%) | Hypothetical Sale Year Adjustment |
| 1 | $5 | $50 | $50 | $450,000 | $126,000 | $67,500 | ($450,000) |
| 2 | $10 | $50 | $50 | $400,000 | $112,000 | $60,000 | ($400,000) |
| 3 | $15 | $50 | $50 | $350,000 | $98,000 | $52,500 | ($350,000) |
| 4 | $20 | $50 | $50 | $300,000 | $84,000 | $45,000 | ($300,000) |
If the goal is to maximize the tax credit available upon final sale, it may make sense to sell the tranche of options that included the highest AMT bargain element upon initial exercise. Or to put it another way, you might want to sell the tranche of shares that included the highest AMT adjustment at exercise. This is because it may have the highest negative adjustment for figuring the AMT credit in the year of sale.
Looking at the chart above, the tranche with the highest AMT impact upon exercise was likely tranche 1, where the exercise price is $5, the FMV at exercise is $50, and an adjustment of $450,000 for figuring the AMT. Assuming the FMV at exercise and final sale are the same, it also may create the highest negative adjustment in the year of sale.
(NOTE – from a practical standpoint, the adjustment you receive in the year you sell qualified ISO is complicated and is calculated as the difference between regular capital gain and AMT capital gain for your entire tax return. Consulting a professional is often a good idea)
Plan Strategically to Get More of Your Alternative Minimum Tax Credit Back, Faster?
It’s not uncommon for planning to occur on the front end of the decisions you make and actions you take around incentive stock options, specifically strategizing how and when to exercise.
But as you can see, the decision regarding which shares to sell on the back end is equally important.
In fact, depending on the value of your options and the bargain element, it’s very possible that selling the “right” tranches of stock may make the difference in accelerating a refund of thousands of dollars of taxes sooner rather than later.
Using the time value of money as our guide (a dollar today is worth more than a dollar tomorrow), it seems to make sense to want to accelerate cash back into our pockets as soon as possible.
Even further, a final sale of incentive stock options will create a cash inflow. What to do with the cash inflow generated from liquidating concentrated equity is another massive decision in and of itself. Still, it creates an opportunity for you to leverage — if you plan appropriately and strategically.
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.
This is really good to know. The long term capital gains rate is not automatically adjusted on exercised shares. It has to be adjusted based on the amount of bargain
Great write up! Now I understand exactly what AMT credits are and how it can be accelerated.
Thanks, Seth – This article is simply one part of a potentially complicated planning need. I encourage you to keep doing your research
Can you help me understand what the actual tax rates apply when ultimately selling a qualifying disposition?
Scenario:
In July 1 2020, I exercise a single tranche of 1000 shares at $5 when the stock price is $105, which is $100k for amt. The amt tax on the $100k is $28000 ($105 fmv-$5 strike price * 1000 shares * 0.28 amt rate), due in April 2021. Let’s assume I have the cash to cover this.
On July 2, 2021, I sell the stock at the current price of $105. The stock was flat. This is a qualifying disposition.
When I file my 1099-b for taxes in April 2022, let’s say I fall into the 15% ltcg bracket. Do I calculate the capital gains on the difference in sale price of $105 and the original cost of $5 per share? Meaning I will owe an additional 15% on the $100k, which was previously taxed at 28%, effectively making it taxed at 43% until an AMT credit could be applied? Or because AMT was triggered previously, is my new capital gains basis 105? Meaning I don’t actually pay any capital gains, and I begin trying to get paid back from amt credits since I over paid.
The confusion here is all about basis when reporting the sale.
If I do get double taxed until an AMT credit can be applied slowly over many years, it seems like the opportunity cost is very high holding long vs getting immediate cash from disqualifying dispositions up to the 24% tax bracket and diversifying each year.
Any help clarifying this is much appreciated. I want to avoid having a massive amt credit that takes 10-20 years to get back, locking up cash. I do intend to seek out a tax advisor or financial planner sometime this year, but I have been unable to find this answer anywhere through internet research.
Thanks!
First of all, thank you for sharing these posts! They are very informative.
I have a question about the scenario where you’ve paid $126,000 in AMT after exercising and holding your incentive stock options and later sold the options in a qualifying disposition. In the example, you actually owed $67,000 but already paid $126,000, an overpayment of $58,500. How does this AMT credit come to be realized? Say the year of the sale you only have regular income (no more ISO exercises), from which taxes have been withheld every paycheck, so you may not really owe anything when it comes time to file your tax return. Would you end up getting a $58,500 refund from the IRS that year? Or is there a limit such that it has to be spread over multiple years?
Another thing I don’t totally understand is whether selling the stock is the only way to get AMT credit? I’d heard you could still get AMT credit the year after you pay the AMT even if you don’t sell the shares you’d exercised. Is that incorrect?
Thanks for the detailed article.
Does California AMT credit work the same way as the Federal AMT credit?
I exercised and paid AMT while being a CA resident, but I am not sure I can get that back if I move out of state.
Indeed, I would then have close to no CA tax liability. Hence, no gap between standard CA tax and CA AMT to apply the credit towards.
Is my assessment correct?
Conceptually, this is a possibility. If no income in CA, and subsequently no “gap,” then possibly no room for credit.
AMT credits, for both Fed and State, can be complicated. And so too might the calculations to determine if a credit is due. It often makes sense to consult with a professional on your personal situation.