Alternative Minimum Tax

How to Use Alternative Minimum Tax Balancing to Manage Incentive Stock Option Cash Flow

Last Updated on September 16, 2020 by Daniel Zajac, CFP®, AIF®, CLU® 1 Comment

If you have employee stock options, you need to determine what kind you have: incentive stock options (ISO) or non-qualified stock options (NQSO).

The differences go far beyond their names. ISOs may provide tax advantages for you, assuming you meet certain requirements. For this reason, many people prefer incentive stock options over NQSOs.

But with the tax advantages come increased complications. The rules around qualifying vs. disqualifying dispositions and the alternative minimum tax can make creating a strategy for your ISOs challenging to do.

What can help is understanding the ins and outs of these rules, how your cash flow may be impacted depending on what you choose to do, as well as tactics you can implement to make the most of your options while minimizing risk and making tax-smart decisions.

If you are looking for a solution that allows you to exercise and hold as many shares as possible and limit the cash call required, an AMT balancing strategy might be the best option for you.

How Qualifying Dispositions Work (and Where Alternative Minimum Tax Matters)

First, you need to understand what counts as a qualifying disposition. This occurs when you sell your ISO shares at least 1 year past the exercise date and 2 years past the date the shares were granted.

Selling incentive stock options this way allows you to pay long-term capital tax rates on any realized gains from the exercise price of the options to the final sale price. But while paying a lower tax rate may sound attractive, exercising and holding your ISOs for at least 1 year that may pose a potential cash-flow problem.

You need to consider how you’ll pay the tax due on the exercise and hold of your options, and you’ll also need to figure out how to pay for the exercise price of the stock shares.

The tax due that may be due is the alternative minimum tax, or AMT. The larger the spread between the exercise price of the ISO and the fair market value of the stock, the larger the potential for AMT.

It’s not uncommon for that spread to be so large that the subsequent tax bill exceeds the amount of cash you have on hand (or at least, requires a cash call much larger than the amount of cash you’d want to send off to the IRS).

One way to manage this potential cash flow problem is to plan an exercise, hold, and sell strategy that focuses on cash flow first. Doing so gives you a way to use AMT balancing when you exercise your ISOs.

The Potential Cash Flow Problem of an Incentive Stock Options Exercise

When you exercise and hold incentive stock options, you may be subject to AMT — and you will be subject to paying the cost to exercise and hold the shares. Let’s assume the following hypothetical scenario to see how much cash these moves could force you to use:

Amount of incentive stock options you can exercise: 10,000
The exercise price of your ISOs: $1.00 per share
Fair market value at exercise: $26.00
Alternative minimum tax rate: 26%

If you exercise and hold 10,000 ISOs, the bargain element is an AMT preference item; this is what you report when figuring if you owe AMT.

In our example, the bargain element is $250,000. If we assume a simple flax 26% AMT rate, that means you owe $65,000 in AMT.

In addition, you also need to pay for the shares of stock when you exercise and hold. In our example, this means paying another $10,000 ($1 per share multiplied by the 10,000 ISOs exercised).

Assuming these numbers, you’d pay a total of $75,000 to exercise and hold these stock options.

If you don’t have the cash on hand (and have it available to use for this specific purpose), you have a problem — but AMT balancing could help you solve it.

Using Alternative Minimum Tax Balancing to Solve the Cash Flow Problem with Exercising Incentive Stock Options

AMT balancing is a method that can help you cover the estimated cash required to pay AMT and for the shares you exercise by using some of the proceeds generated by exercising and then selling a portion of your ISO shares.

This means that, in lieu of an exercise and hold of 100% of your incentive stock options, you exercise and hold some ISOs while you exercise and sell some of the others.

The proceeds of the ISOs you sell can then be used to pay the tax bill and the cost to buy the shares. This is one of the biggest benefits of AMT balancing: you’ll end up holding a smaller position in company stock, but you’ll also reduce how much cash you need to pull out of pocket to cover the exercise transaction itself.

In addition to limiting or eliminating the amount of cash flow required to exercise and hold your ISO shares, AMT balancing can also help limit your exposure to a single company stock. The reduced position you’d most likely have (versus exercising and holding all your shares) may be a good thing if you are risk-averse, seeking to diversify your portfolio, or don’t want such a large amount of your net worth tied up in the same company that signs your paychecks.

Another benefit of AMT balancing is immediately realizing profits. Realized profit is something you don’t receive when you have ISOs that you exercise and hold. Holding shares means you continue to assume the risk/reward tradeoff associated with a single stock position, which may not align with your overall financial plan or investment strategy.

How Alternative Minimum Tax Balancing Works

Let’s go back to our example above to help illustrate how AMT balancing can work. We already established that the total cash necessary to pay the AMT and to exercise and hold your ISOs is $75,000.

If you used an AMT balancing strategy instead of exercising and holding all your shares, you’d need to ask, “How many ISOs need to be sold immediately after exercise to end up in a cash flow neutral position?”

To calculate the shares required, you divide the total cash you need to cover your expenses and taxes by the fair market value of the stock. (Note that this assumes that you exercise and sell the required ISO shares immediately.)

In our example, the number of shares required to be sold is:

Estimated Shares Required to be Sold = Cash Need / FMV of the Stock

$75,000 / $26.00

2,884 Shares (rounded down)

Total Proceeds from the Sale = $74,984

Post-sale, the $74,984 in proceeds can be used to pay the pending AMT bill as well as to cover the cost to buy the shares. This means that you will need to pay $16 out of pocket and that you will retain 7,116 shares post-transaction (the 10,000 ISO shares you started with, minus the 2,884 you sold to cover costs).

A Detailed Look at a More Complex Alternative Minimum Tax Balancing Scenario

Income tax rules for incentive stock options, the AMT, and compensation income tax rates will likely make a real-life scenario more complex to work through than the simplified example we used above.

In fact, as you exercise and hold some ISOs and exercise and sell others, you transition into a world that includes both AMT preference item reporting and compensation income reporting. This means that different tax rules will apply to different portions of the exercise transaction.

ISO shares that will be sold in a disqualifying disposition because they are exercised and sold rather than held will be subject to compensation income tax rates. In our example, 2,884 shares would be subject to this kind of tax treatment.

Meanwhile, the ISO shares that were exercised and held would be subject to AMT (assuming they are held past year-end). In our example, that’s 7,116 shares subject to AMT rates.

If we illustrate the qualifying and disqualifying disposition separately and show the cash flows from each transaction, we can see more clearly the cash flows required to exercise and hold the ISOs, the proceeds from the exercise and sale of the disqualifying disposition, and the AMT and compensation tax due:

	Qualifying Disposition	Disqualifying Disposition
Shares	7,116	2,884
Cost of Shares	($7,116)	($2,884)
AMT (26%)	($46,254)	0
Proceeds from Sale	$0	$74,984
Compensation Income (24%)	$0	($17,304)
Net Cash Flows	($53,370)	$54,796

By adding the net cash flows from the two portions of the transaction, you can see a positive total cash flow of $1,426. This is where AMT balancing can help you break even or even have a net cash flow, and not pay cash out of pocket

(It should also go without saying that you should complete a personal tax projection to determine how this strategy may work for you and what the exact figures may be. Using an expert who understands the complexities around equity compensation and how various parts of that compensation will be taxed can be extremely valuable.)

What AMT Balancing Means for Incentive Stock Options and Your Comprehensive Financial Plan

Much of the attention pertaining to incentive stock options address the AMT, AMT credits, and potentially preferential tax treatment. Unfortunately, these conversations may fail to address a similarly important part of the conversation: cash flow.

By giving attention to cash flow, you can begin to understand how your exercise decisions may impact you in the near term.

You need to know how much cash you will need to exercise and hold shares, whether or not you can actually afford a specific ISO strategy, and where the cash will come from if you’ll use it to exercise and hold shares.

By answering these questions, you can begin to implement a strategy that addresses your investment risk tolerance, your tax preference, and your ability to fund the plan per your other assets. Only then can you decide whether an AMT balancing strategy is in your best interest.

The content herein is for illustrative purposes only and does not attempt to predict actual results of any particular investment. Diversification does not guarantee a profit or protect against a loss. 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.

What You Should Know About the Alternative Minimum Tax

Last Updated on April 15, 2020 by Daniel Zajac, CFP®, AIF®, CLU® Leave a Comment

The alternative minimum tax (AMT) acts as a sort of parallel tax system to the regular federal income tax system. For taxpayers, this means they need to calculate their income twice: once under the regular tax rules and a second time under AMT. After running this calculation, taxpayers then pay whichever is highest.

AMT was implemented in 1969 to ensure individuals earning high income pay their fair share in taxes. The problem, however, was that AMT was not originally adjusted for inflation. The end result caused many middle-class taxpayers to be unnecessarily subject to paying AMT.

The new rules that updated requirements around paying AMT were introduced recently, and went into effect for the 2018 tax year. Both exemptions and phaseout limits were increased, meaning it’s less likely you’ll need to pay AMT.

Unfortunately, if you have incentive stock options and plan to exercise and hold them, even the recent changes may not be enough to help you avoid AMT completely.

Because of that, you should take the time to familiarize yourself with this tax as it’s possible you may need to pay it in the future.

How Is AMT Calculated?

To calculate AMT, you first need to calculate your Alternative Minimum Taxable Income (AMTI). AMTI is a different calculation than the calculation for your regular taxable income. It adds back certain deductions and adjustments into your taxable income, and many of deductions you enjoy on regular federal taxes do not apply.

AMTI also includes the bargain element (the difference between the exercise price of your stock option and fair market value at exercise, multiplied by the number of shares purchased) of exercising your incentive stock options as income.

For comparison, the bargain element is not counted when figuring your regular income if you exercise and hold the shares. The result of its inclusion in income means exercising ISOs may inflate your AMT in the year you exercise your incentive stock options.

Once your AMTI is calculated, then the exemption is applied to find your Alternative Minimum Tax Base:

Alternative Minimum Tax Base = Alternative Minimum Tax Income – Exemption

If your AMTI is below the 26%/28% Dividing Line, you’ll be taxed at a flat 26% rate. If AMTI is over the dividing line, then the portion of your income below the dividing line is taxed at 26% and the remainder is taxed at 28%.

A Note on the Exemption

If your income is high, part of your exemption may go away. This is known as the phaseout. If you fall into the phaseout, then $1 disappears from your exemption for every $4 above the phaseout.

For individuals with extremely high incomes, your exemption can be reduced to zero.

Tax Filing Status	2018 Exemption	2019 Exemption	2018 Phaseout	2019 Phaseout	26% / 28% Dividing Line
Single	$70,300	$71,700	$500,000	$510,300	$97,400
Married File Jointly	$109,400	$111,700	$1,000,000	$1,020,600	$194,800

Using an Example to Show the Impact of the Alternative Minimum Tax

Let’s assume you’re a married taxpayer and you have an AMTI of $1,050,600 in 2019. You have exceeded the phaseout limit by ($1,050,600 – $1,020,600) = $30,000.

This means you need to recalculate your exemption, which is $111,700 if you did not exceed the phaseout. Your new exemption is your full exemption amount less a quarter of the amount they exceed (0.25 x $30,000) = $7,500.

That makes your new exemption ($111,700 – $7,500) = $104,200, and your new Alternative Minimum Tax Base ($1,050,600 – $104,200) = $946,400.

Remember there are two tax rates: 26% for the amount under $194,800 and 28% for the amount over. Given this, your tentative minimum tax would be:

26% x $194,800 + 28% x ($946,400 – $194,800) = $261,096

If this amount exceeds your regular tax, the amount in excess is the AMT you have to pay. For example, if your regular tax is $150,000 and your tentative minimum tax is $261,096, you will pay $111,096 in AMT.

AMT Counts Exercising Incentive Stock Options as Income

Exercising your incentive stock options counts as income for AMTI calculations, even if the gains are not realized. The calculation of regular tax, on the other hand, does not consider buying and holding a taxable event.

Specifically, the bargain element, which is the difference between the price of your options and the market price multiplied by the total number of stocks purchased, is included in the calculation.

This is not to be confused with a capital gains tax, which is the tax paid when stock is sold.

Since AMT counts exercising incentive stock options as income, it can lead to an unexpectedly high amount of taxes owed for the year.

Imagine if you exercised 10,000 incentive stock options for Company X, for which you had an exercise price of $5 a share. If the current stock price is $85 a share, then the bargain element per share would be: ($85 – $5) = $80. If all 10,000 shares were exercised, the total bargain element would be $80 x 10,000, or $800,000.

If this were a non-qualified stock option, the entire $800,000 would be taxed as ordinary income in the year of exercise, regardless of whether or not share shares were subsequently sold or retained.

Incentive stock options — and subsequently, the calculation of the AMT — treat the $800,000 of bargain element as if it were a non-qualified stock option (assuming the shares are held past the calendar year end).

The entire $800,000 is included as income when calculating AMT, even though it is not included as income for regular tax purposes. Only when the shares are sold in a final sale will they be included in the regular tax calculation.

Continuing the example, $800,000 of income is included in the calculation for AMT. Given the AMT tax rate of about 28%, the taxpayer’s AMT may grow by over $220,000.

The AMT Credit

Fortunately, selling your incentive stock shares does not create more AMT taxes. Instead, it may lead to something called AMT credit — and that’s a good thing. It may lower your AMT amount the year in which you sell your incentive stocks.

When you sell your incentive stock option shares, the income that was included for calculating AMT when you exercised the shares is now a negative deduction in the year of sale. This negative deduction may lead to a tentative minimum tax that is lower than your regular tax.

If you have a tentative minimum tax that is lower than your regular tax and you have carryforward AMT credit, you may be able to get that credit back in the year of sale. The result may mean a lower tax bill than you would have had otherwise.

In fact, its possible that liquidating your incentive stock can potentially result in enough AMT credit to cover the full AMT tax you initially paid. But there is a cap on how much AMT credit you can gain in a year.

If you don’t use your full AMT credit in one year, it carries forward to subsequent years for future use.

The AMT Crossover Point

It is possible to avoid paying AMT when exercising incentive stock options, but this requires good tax planning and knowing your AMT crossover point.

The AMT crossover point is the point where your AMT tax becomes higher than your regular tax. Remember how AMT is only paid when it is higher than the ordinary tax rate? This crossover point can be used to your advantage when exercising ISOs.

When you exercise an incentive stock option, the bargain element is counted as income under AMT. For large transactions, this can bump the AMT higher than regular tax.

However, if your AMT tax rate is lower than your regular tax rate, then you have room to exercise some incentive stock options without paying AMT.

To do so, you can calculate the difference between your regular tax and AMT tax. Once you know the difference between the two, you can use this as an indication to determine how much bargain element you can incur and use that information to determine how many ISOs you can exercise.

The larger the spread between the regular tax and the tentative minimum tax, the more stock you can buy. The smaller the spread, the less stock you can buy.

Let’s assume that you want to exercise some of your ISOs and that you have calculated your regular and AMT taxes to be the following:

Regular Tax: $70,000
Tentative Minimum Tax: $50,000

In this scenario, you need to pay the higher of the two calculations, which is currently $70,000 in regular tax. It also means you have a spread of $20,000 between the two tax calculations.

It is possible to determine how much incentive stock to buy by dividing the spread by the AMT tax rate of 28%:

$20,000 / 0.28 = $71,428.57

This number indicates the taxpayer can exercise and hold $71,428.57 worth of bargain element without paying additional AMT taxes.

If we further assume that you have incentive stock options with a bargain element of $100 per share, we can determine that you can exercise 7,142 shares (rounded down) to fill up the entire AMT free bucket.

$71,428.27 / 100 = 7,142 options

Key Takeaways

The alternative minimum tax is not new, but recent changes have increased exemption and phaseout limits. These changes make AMT more forgiving towards the middle class, but may also give more opportunity for exercising incentive stock options without incurring extra taxes.

It is possible to minimize AMT payments by planning the number of incentive stock options you purchase around the difference between your AMT and regular tax owed.

However, this step requires precise planning and calculations and may be best done near year-end. This likely minimizes any taxable surprises from occurring.

Ultimately, every tax situation is different, and you should run a detailed tax calculation for AMT (or with an advisor) before making a final decision on what strategy is best to use around your stock options.