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.
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:
|Fair Market Value at Exercise||$50.00|
|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 ever pay 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 be taxed as ordinary income.
The answer is that the AMT is a prepayment of expected taxes due. 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 “prepaid” taxes 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. That’s the AMT credit opportunity.
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):
|Fair Market Value at Exercise||$50.00|
|Fair Market Value Final Sale||$50.00|
|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 accelerate 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%)||Sample Spread for Credit|
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 prepayment of taxes.
In our example, the highest prepayment of taxes is on the tranche of shares with the largest spread between the exercise price and the FMV at exercise. That’s the one with the highest bargain element.
Looking at the chart above, the tranche with the highest AMT impact upon exercise was likely tranche 1, where the exercise price is $5, and the FMV at exercise is $50. Using our same tax sample from above, tranche 1 has the opportunity to accelerate $58,500 in tax, as opposed to tranche 4, which will only accelerate $39,000.
The decision here is nearly a $20,000 difference.
(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.