Most people understand that taxes can be a little more complicated when you have incentives stock options and other equity compensation. What they may not know is that income tax isn’t just about tax brackets to calculate your regular taxable income. The federal income tax system has a sister system that figures how much tax you may owe due to the Alternative Minimum Tax (AMT). AMT may kick in when your income goes over a certain threshold or when you engage in certain activities, namely exercising and holding incentive stock options.
Alternative Minimum Tax can be a bit daunting, and it can complicate your decision to exercise and hold or exercise and sell incentive stock options. If you do plan to take action with your incentive stock options, it’s important that you consider if you may owe AMT, how much you may owe, when it will be due, and how you may handle the cash call required to cover the said tax bill.
Here’s an introduction to what you need to know about AMT:
Does the Alternative Minimum Tax Apply to Me?
AMT can apply for a variety of reasons such as having certain business deductions or exercising and holding incentive stock options. To figure whether you owe AMT, you’ll need to complete Form 6251 on your tax return.
Form 6251 will lead you to calculate your tentative minimum tax. Generally speaking, if your tentative minimum tax is higher than your regular tax, you will owe AMT. AMT, as calculated, is the difference between the tentative minimum tax and the regular tax in years you’re your tentative minimum tax is the higher of the two.
The reason that AMT may be more common in years when you exercise and hold ISO is that the bargain element, or the spread between the exercise price of your stock option and the fair market value of the stock at exercise (multiplied by the number of ISO exercised) is an adjustment item when figuring your TMT. It is not an item when figuring your regular tax. This difference in accounting is what makes the AMT common in years that taxpayers exercise and hold ISO.
How do I Calculate my Alternative Minimum Tax?
The AMT system is a parallel system to the standard income tax system. You’re allowed certain deductions, but they’re not the same deductions you’re allowed on your regular income taxes. AMT is calculated using IRS Form 6251.
You or your tax professional will use Form 6251 to calculate your allowable deductions and figure your alternative minimum taxable income for the AMT. This amount may be different from your taxable income under the regular system. The AMT system does allow for some exemptions, depending on your filing status and the amount of your alternative minimum taxable income.
After your deductions and exemptions are entered, you’ll use the form to calculate your alternative minimum tax.
How Incentive Stock Options Impact my Alternative Minimum Tax?
There are several different factors that can impact the amount of AMT you pay. The most common of these include activities like exercising and holding your incentive stock options past the calendar year-end.
Incentive Stock Options
If you exercise and sell incentive stock options in the same calendar year, there is no adjustment on form 6251 for figuring the AMT in that calendar year. Generally speaking, any gain will be taxed as some combination of ordinary income and short-term capital gain (if any).
If you exercise and hold incentive stock options past the calendar year end, there is an adjustment on your tax return for figuring the AMT. The adjustment is based on the bargain element incurred at exercise.
For example, let’s say you have 10,000 ISOs with a strike price of $1 per share, and when you exercise these ISOs, the fair market value at exercise is $50 per share.
The difference between FMV at exercise ($50) and the strike price of the ISO ($1), multiplied by the number of ISO exercised (10,000), is the bargain element ($490,000).
The bargain element is included as “income” on form 6251 and is potentially subject to the AMT.
If we assume a flat 28% tax AMT rate on $490,000 of bargain element, the total AMT due would be $137,200.
There are ways to exercise your ISOs that can help you mitigate the AMT when you exercise your ISOs. Any strategy you choose will require careful planning, as there are other tax implications associated with ISO dispositions that you’ll need to be aware of, too.
How can I Manage my AMT when I’m Exercising my ISOs?
There are a number of ways to manage AMT when you decide to exercise your incentive stock options. However, they all have potential advantages and disadvantages, and there is often no one set strategy to work best for everyone. Here are a few ideas that you might consider in order to manage your AMT.
Exercise your ISOs when the strike price is close to the fair market value (FMV).
If you are in a pre-IPO company, have the option for an 83(b) election, or are otherwise in a situation where the current FMV is close to the strike price of the option, exercising your options sooner rather than later may be something to consider. This helps to reduce the bargain element, which reduces the amount you’ll owe in AMT. For example, if your exercise price is $1 per share and you want to exercise your option to purchase 10,000 shares, but the value of the shares is only $1.10, your bargain element would be $1,000, an amount low enough that it may not even trigger AMT.
A big obstacle to this strategy is that you are often buying shares of stock of a company that may be in its early stages. If you are pre-IPO, you may not even be able to sell your shares. If your company is public and has a readily available market, exercising when the FMV is equal to the strike price means giving up stock options leverage, and the ability to “control” the value of the with little (no) cash outlay.
Only exercise the options that keep you below your AMT crossover point.
The calculation for figuring the regular tax and the tentative minimum tax is figured every calendar year. Often, assuming no ISO activity, the regular tax is the higher of the two and no AMT is due.
If you have ISO, knowing that your TMT is lower than the regular tax presents an opportunity. It’s possible that you can exercise and hold some amount of ISO, up to the point where the TMT equals the regular tax, and still not pay AMT. This is commonly referred to as the AMT crossover point.
AMT Balancing, using some of your ISOs to cover the tax bill.
If you are seeking to exercise and hold incentive stock options and not have to come up with cash to do so, you may want to consider a partial exercise and hold and a partial exercise and sell. With this technique, you immediately exercise and hold some shares, hoping to obtain preferential tax treatment, and exercise and sell others, creating a cash inflow that can be used to offset a pending tax bill.
Following our above example, let’s say that you have10,000 options valued at $50 each for a $1 strike price.
Using AMT balancing, you would exercise and hold some of the shares, creating an AMT adjustment on form 6251. You would also exercise and sell others, leading to ordinary income tax, but a positive cash infusion. This cash can then be used to cover the pending tax bill.
While the calculation for AMT balancing goes beyond this article, this strategy may allow you to meet the dual objectives of obtaining long-term capital gains while mitigating the out of pocket cash flow required to do so.
Exercise Early in the Year
The calculation to determine your alternative minimum tax is based on a calendar year. If you exercise your ISOs and hold the shares past the year’s end, the bargain element will be included on your tax return for the year you exercised your options.
However, exercising your options early in the calendar year may help you solve this problem. When you exercise your ISOs and then sell the shares, you can pay your AMT bill with that income. An early exercise can also begin your holding period for a qualifying disposition earlier in the year.
For example, if you exercised your shares on March 1, 2020, then you would owe your AMT as part of your 2020 taxes, and this amount would be due in April 2021. However, if you have held your stocks for more than a year past the exercise date, you could sell those stocks on March 15, 2021, and use those proceeds to pay the AMT bill, while the sale of those shares would count as a qualifying disposition.
This is a complex strategy that requires careful timing. It’s not a strategy to avoid AMT, but one to help you cover the cost without dipping into your existing assets. Consider this strategy carefully with your financial advisor.
What About the AMT Credit?
AMT can be thought of as a pre-payment of tax due on your ISO. As a pre-payment, it only makes sense that this comes back to you at some point in time.
Generally speaking, this pre-payment of AMT may be accelerated back when you sell your previously exercised and held ISO shares in a qualifying event.
When you sell your ISO shares, a new calculation of regular capital gains and AMT capital gains is figured that may lead to a negative adjustment on Form 6251. It’s possible, that the full AMT adjustment that was attributed to you as the bargain element in the year of exercise and hold is now calculated as a negative deduction in the year of your sale. This can lead to a tentative minimum tax that may be lower than what you would owe under the regular tax system. When your tentative minimum tax under the AMT system is lower than your regular tax and you have an AMT credit, you may be able to get some of that credit back.
It’s important to note however, that the calculation for AMT credit is nuanced, and that it is possible that you may not receive the full amount of AMT that you paid in the year of exercise in the year of sale. Sometimes, AMT credit can be carried forward for years and trickle back over time. Good planning with your ISOs may lead you to take full advantage of the credit as a part of your overall AMT strategy.
How Does the Alternative Minimum Tax Impact My Overall Strategy?
The Alternative Minimum Tax can be a major concern for people who are exercising their incentive stock options, and it’s important to understand the timing and strategy related to this parallel tax system.
As so many of these investments may also trigger capital gains taxes and interact closely with other investment decisions, it’s important to consider the overall strategy and financial planning picture when making choices about ISOs and how they work within your larger financial plan.
Ultimately, every financial and tax situation is different. Ideally, you’ll want to run a detailed tax calculation or speak directly with an advisor before making a final decision on how best to manage your AMT concerns this year.
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.
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.