The alternative minimum tax is a supplemental tax that may be due, in addition to regular income tax, for calendar years during which a taxpayer has a special circumstance that causes the tax to be due. The exercise of incentive stock options is one of these special circumstances that often leads to AMT.
Typically, the amount of tax owed by a taxpayer (or taxpayer family) is subject to the rules and regulations of the regular tax law. This tax law is the commonly discussed water cooler conversation of which most taxpayers are aware.
What most taxpayers are not aware of is that even during years in which regular tax is paid, the alternative minimum tax is calculated. The calculation of AMT is subject to a separate set of calculations than the regular tax calculation. As long as this AMT calculation remains the lower of the two, AMT goes unnoticed. As a taxpayer, you are required to pay the higher of the two tax calculations: regular tax or the alternative minimum tax.
The calculation for AMT is figured based on a nearly flat tax rate of 26% and 28% percent. For 2018, the first $191,500 of your AMT income is taxed at 26%, and any amount in excess of $191,500 is taxed at 28%.
The calculation for determining AMT income is also different than what is used for determining regular taxable income. Some key differences when calculating AMT include the removal of deductions for real estate tax and income tax and the removal of exemptions. For incentive stock options, the “bargain element”, while not included in compensation income for calculating regularly taxable income, is included when determining AMT income.
For those with incentive stock options, an exercise event can make a significant difference in the amount of tax that is due. So much so that tax liability in the year of exercise could potentially be much larger than what would have been due under the regular tax calculations.
Why Does the AMT Matter?
The AMT matters for many reasons. Arguably, the most important reason why AMT matters is cash flow.
When you exercise and hold incentive stock options, the bargain element is included as income when calculating the alternative minimum tax. A high bargain element may cause additional tax to be owed at tax time. As the value of the bargain element increases, so does the potential tax due for the AMT. A large tax bill begs the question – where does the cash come from to pay the requisite taxes due?
Using an example to illustrate, let’s assume we have 10,000 incentive stock options with a grant price of $1 per share and an exercise price of $50 per share. Lets further assume an exercise and hold. In this example, the option holder will need to supply the following cash:
- To buy the shares at exercise: $10,000
- This is calculated by multiplying the number of shares exercised by the grant price per share.
- To pay the tax at tax time (assuming a 28% flat AMT): $137,200
- This is calculated by multiplying the tax rate by the exercise price, less the grant price.
In this scenario, an exercise and hold and AMT may result in a significant cash requirement (in addition to what would be owed under the regular tax law) for those who wish to perform an exercise and hold. The option holder needs to come up with $147,200 to buy the shares and pay the tax.
For many, finding an extra $147,200 lying around to pay taxes with is not easy. In fact, for many, it may not even be an option. They may be forced into other exercise strategies that create cash to cover the tax and exercise cost.
For those who have available cash, the question needs to be asked whether they want to use this to buy and hold shares. By doing so, they may be doubling down on their investment in the company stock by taking otherwise non-company stock assets and making them company stock.
A Pre-Payment of Tax and the AMT Credit
One can think of AMT as a method that can be used to pre-pay potential tax due. In effect, the AMT could be considered a strategy that is forced by the IRS to be sure they receive what is due to them.
Assuming a qualifying disposition, “squaring up” on your pre-payment with the IRS begins when exercised shares are subsequently sold.
Upon the final sale of shares (and assuming they are qualified), the spread from the grant price to the final sale price is subject to preferential long-term capital gains treatment. If we assume that long-term capital gains rates are 15%, it would be reasonable to assume the difference between 28% AMT prepayment and 15% long-term capital gains should be equalized. In effect, squaring up occurs with the AMT credit.
Continuing our example from above, $137,200 was paid due to AMT in the year the options were exercised. This tax calculation was based on a 28% AMT rate. If we assume these same shares are sold as a qualified disposition and subject to a tax rate of 15%, the total tax paid is $73,500. Therefore, the difference between AMT paid and the tax required upon performing a qualified disposition is $63,700. This amount, $63,700, is potentially available as a tax credit (said another way, an overpayment of AMT tax).
Unfortunately, the math behind just how much is recovered via the AMT credit is not as simple as advertised above. In fact, it’s not impossible for some of the AMT credit to never be fully recovered, even if a qualified disposition is performed for all shares.
While the full scope of the AMT is beyond this article, it’s important to know that you may be able to get back some or all of the AMT paid, but you also may not get it all. For this reason, it may not always be in your best interest to try to exercise all of your incentive stock as a qualified disposition. This is potentially even more true for those who are cash strapped and may not be able to afford an exercise and hold.
A personalized tax projection with various assumptions for tax and growth rates can help you evaluate an AMT credit-balancing projection. This analysis is intended to maximize the number of shares that are exercised and held, while not leaving any of the AMT credit unused.
Tax services are not offered through, or supervised by Lincoln Investment, or Capital Analysts.
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.