When you exercise and hold incentive stock options, it’s very possible that you will be subject to the alternative minimum tax (AMT). This part of the tax code gets complex, making it difficult to understand.
One way to think of the AMT is a pre-payment of income tax on exercised incentive stock options — but actually dealing with AMT is a lot more complicated than simply changing the way you think about it.
The amount you could owe due to AMT can be massive, and may potentially require you to find significant cash to cover the pending tax bill. Without that cash on hand to pay your bill, immediately exercising and selling your incentive stock options via a cashless exercise might be your only option.
But that presents problems, too. A cashless exercise effectively turns incentive stock option into a non-qualified stock option.
Said another way, you take what could be taxed at preferential long-term capital gains rates and cause it to be taxed as ordinary income. This is known as a disqualifying disposition.
If you find yourself dealing with AMT, it’s common to begin by asking this question:
How can I lower the amount of AMT I pay?
The short answer is simple (and touched on above). You can typically lower your alternative minimum tax liability to $0 if you exercise and sell your incentive stock options in the same calendar year. Again, this move requires making an intentional disqualifying disposition.
And it could be a short-sighted strategy. You might avoid the alternative minimum tax, but that doesn’t mean you’ll come out ahead financially.
Fortunately, there are other options that can help you manage your AMT liability in a way that allows you to possibly reap the other benefits associated with incentive stock options. Let’s take a look at 4 of them.
1 – Exercise Early in the Calendar Year
Exercising early in the calendar year is one strategy to potentially avoid (or at least lower) your alternative minimum tax bill. This gives you the opportunity to see how your stock performs from the date of exercise until the calendar year-end.
I specifically and intentionally say “calendar year-end,” which is December 31st , because the strategy below requires you to make the sale of your stock before close of business on December 31 in order to effectively and potentially lower your AMT. If you exercise and hold your ISOs on January 1, the exercise and hold is reportable for AMT.
If your stock price goes up in value between the time you exercise your shares and the time you check the stock near year-end, you’ll probably want to hold your stock and pay the requisite AMT.
But what if your stock price goes down between the exercise date and the end of the year? In that case, selling your stock prior to close of business on December 31 in an intentional disqualifying disposition might be an optimal strategy because it’s possible that you could owe more in AMT than your stock is worth.
Let’s use an example to see how this works. We’ll assume the following:
- ISOs Exercised: 10,000
- Exercise Price: $1.00
- Fair Market Value at Exercise: $50 per share
- Exercise Date: January 1
In this example, the amount that is a reportable transaction (assuming the stock is held past the calendar year end) for AMT (known as the bargain element) is $490,000. The calculation is as follows:
Bargain Element = (Fair Market Value at Exercise – Exercise Price) * Shares Exercised
If we also assume this amount is subject to AMT at 28%, we can calculate a pending tax bill of $137,200. If the exercised ISOs are held past calendar year-end, that’s what you’ll owe.
By exercising early in the calendar year, however, you can give yourself more of an opportunity to evaluate whether holding the shares is a good or bad idea.
If the stock price increased, it may make sense to continue to hold the shares of stock past the calendar year-end. The short term “cost” of the AMT may be secondary to achieving preferential long-term capital gains treatment on an appreciating stock.
If the stock price at year-end is below the fair market value when you exercised, it might make sense to undo the exercise of your ISOs. You can do so by selling the previously-exercised stock in a disqualifying disposition.
If you sell prior to year-end in a disqualifying disposition, the bargain element (and subsequently, the pending AMT tax bill) disappears. Instead, you’ll be responsible for paying tax on any gain or loss recognized from the exercise price to the final sales price (the exact tax details are subject to the timing of your transaction and whether or not you have a gain or loss).
Following our example above, we can assume a $137,200 tax bill if the stock is held past calendar year-end. But now let’s say that since exercising the ISOs, the price of the stock dropped from $50 per share to $20 per share.
Assuming the same 10,000 shares, we have the following:
- Market Value of the Stock: $200,000.
- Pending AMT Tax Bill: $137,200
- After-Tax Value (Market Value less AMT Bill): $62,800
If you choose to undo the exercise of ISOs, you wouldn’t pay the $137,200 AMT tax bill. Instead, you would be responsible for paying ordinary income tax on the spread between the final sales price and the exercise price, as per the rules of a disqualifying disposition.
Continuing with our example, that means we’d have:
- Market Value of the Stock: $200,000
- Cost Basis of Stock: $10,000
- Pending AMT Tax Bill: $0
- Ordinary Income Tax Bill: $62,700 (assuming $190,000 of taxable income at 33%)
- After-Tax Value (Market Value less Ordinary income tax bill): $137,300
As you can see, performing a disqualifying disposition may actually leave you in a significantly better after-tax position.
Exercising early in the year gives you the opportunity to see what your AMT bill will be, and calculate this against the near year-end value of the stock. This timing can help you plan whether it makes sense to retain the stock and pay AMT, or sell the stock and possibly lower your AMT.
2 – Exercise Late in the Calendar Year
As your approach the calendar year-end, you’ll likely have greater certainty regarding your income and expenses for the year. That, in turn, can make it easier to confidently project what your tax return will look like come April.
Using this projection, you can calculate how many incentive stock options you can exercise without having to pay AMT. To figure this calculation, it’s necessary to take a moment and explore tax law.
Every year you file your tax return, two calculations are performed to determine how much tax you owe (or how much refund you get):
- The regular tax, which is tax you owe based on the normal tax rules of which many are aware.
- The tentative minimum tax, which is impacted by the exercise of incentive stock options and may cause you to owe AMT.
As a taxpayer, you pay the higher of the two. In most years, especially years when you don’t exercise incentive stock options, the regular tax will probably be higher. But understanding the results of these two calculations close to year-end gives you the opportunity to see if you can lower your AMT.
If we assume your regular tax is higher than your tentative tax, we can also assume it might be possible to exercise some incentive stock options and continue to stay under the regular tax base.
By doing so, you can effectively exercise ISOs without owing AMT.
Let’s assume a taxpayer projects their tax return at year-end and calculates a regular tax of $50,000 and a tentative tax of $35,000. Prior to owing AMT, the tentative tax base would need to exceed $50,000 in order to cause you to pay that instead of the regular tax.
Using this information and assuming a 28% tax rate for the alternative minimum tax, we can calculate how many ISOs you can exercise without potentially triggering a AMT bill.
Total Exercisable Bargain Element = (Regular Tax – Tentative Minimum Tax) / AMT Rate
= (50,000 – $35,000) / .28
This means there is hypothetically $53,571.43 of “opportunity” to exercise and hold incentive stock options without owing AMT.
3 – Exercise When the Spread Between Your Exercise Price and the Fair Market Value Is Small
The amount of AMT you owe is directly related to the spread between the exercise price of your incentive stock options and the fair market value when you exercise. Generally speaking, a small spread means owing less AMT and a big spread means owing more AMT.
If you want to lower your AMT, then exercising your incentive stock options when the spread is small may be your best course of action.
Let’s assume you have two grants of 10,000 options that you exercise at $50 per share. Grant 1 has a exercise price of $1 and Grant 2 has an exercise price of $40.
If we compare these two grants and their impact on the AMT, we calculate a very different tax due for each. Using a flat 28% tax bracket and an exercise of 10,000 shares each, we can calculate the following:
- Grant 1 AMT – [10,000 * (50 – 1)] * .28
- AMT = $137,200
- Grant 2 AMT – [10,000 * (50 – 40)] * .28
- AMT = $28,000
If you believe that your company stock price will appreciate, it’s reasonable to assume that the spread between the fair market value when you exercise and the exercise price will become larger. Here’s why:
Let’s assume an exercise price of $10 per share now, and $50 per share later:
- Grant 1 AMT short term – [10,000 * (10 – 1)] * .28
- AMT = $25,200
- Grant 1 AMT long term – [10,000 * (50 – 1)] * .28
- AMT = $137,200
Timing of the incentive stock exercise of the same grant and valuing the spread between two types of grants can both create opportunities to lower your AMT. But these strategies may or may not be in your best interest from a big-picture perspective.
For example, if you exercise when the spread is small, you have to balance minimizing AMT, managing your investment risk tolerance, and affording the cash flow associated with such an event. (How you are going to pay for the stock you need to buy and how you are going to pay the pending tax bill?)
When you exercise your stock, you move from having the option to do so (at no cost to you) to actually buying the stock with real money. Exercising means assuming investment risk of owning a stock outright.
That might work perfectly fine in the context of your larger financial plan — but it’s something to consider before you execute this kind of strategy around your ISOs in an attempt to lower your AMT liability.
4 – Sell Previously Exercised ISOs Strategically to Accelerate the Tax Credit
The AMT calculation has two key parts:
- Owing alternative minimum tax
- Getting what you paid for AMT back in the form of a credit.
The AMT credit allows you get back some or all of the previously paid AMT. This occurs when you sell previously exercised incentive stock option shares.
It’s common to have several different years in which you exercised and held incentive stock options. Typically, these “lots” have different exercise prices and fair market values when your exercised. This information can lead to different outcomes when figuring the AMT credit.
In an effort to maximize your AMT credit, you should consider selling lots of incentive stock options shares with the highest spread between the fair market value when you exercised and the exercise price of the option. These lots will likely be the ones on which you paid the most AMT, so it makes sense they may have the greatest opportunity for AMT credit.
The calculation to determine how much AMT credit you will receive goes back to comparing your regular tax and the tentative tax.
As we discussed above, when you exercise ISOs and the tentative tax is higher than the regular tax, you likely pay AMT. When you subsequently sell previously exercised ISOs, the opposite happens. You can drive the tentative tax down below the regular tax.
Driving the tentative tax lower can create a tax spread, and along with previously paid AMT, can lead to a tax credit. The larger the spread, the greater the potential tax credit.
All else being equal, you can drive the tentative tax down by exercising the lots of exercised incentive stock options that have the greatest spread between original exercise price and the fair market value when you exercised.
Incentive Stock Options and the AMT
Discussing the alternative minimum tax is common when evaluating exercise strategies of incentive stock options. For many, the first time they exercise ISOs is the time they will be introduced to AMT.
Couple the “newness” of the AMT with a potentially large tax bill, and you rightfully have the recipe for confusion.
While consideration should be given to AMT, especially AMT in the near term due to exercise, it’s equally important to see that back-end planning can occur as well. A combination of short-term tax planning and long-term tax planning can help you evaluate the best strategy to implement.
In addition, tax is simply one part of the discussion. A complete financial plan will give the requisite consideration to tax, but it should also evaluate investment risk tolerance and capacity in the context of your personal goals and objectives to better balance all your wants and needs.
None of the information in this document should be considered as tax advice. You should consult your tax advisor for information concerning your individual situation. Tax services are not offered through, or supervised by, The Lincoln Investment Companies. Projections or other information regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results and are not guarantees of future results. Additionally, it is important to note that information in this report is based upon financial figures input on the date above; results provided may vary.