If you have incentive stock options, you’ve likely heard the term alternative minimum tax, or AMT. But what is the AMT, and how is it calculated?
It’s a type of income tax, but very different than what you may be used to paying.
Typically, the calculation of your total income tax due is subject to the rules and regulations of the regular tax law. This regular tax is the commonly-discussed water cooler conversation of which most taxpayers are aware of.
What most taxpayers are not aware of is a second calculation, the tentative minimum tax, that also occurs every year.
AMT and The Impact of Higher Tentative Minimum Tax
As a taxpayer, you pay the higher of the two tax calculations: regular tax or tentative minimum tax. As long as the tentative minimum tax calculation is lower than the regular tax calculation, you don’t owe AMT.
But if the tentative minimum tax is higher than the regular tax, you’re subject to AMT. AMT is the difference between the tentative minimum and regular tax when the tentative minimum is the higher of the two.
Exercising and holding incentive stock options is one thing that can increase your tentative minimum tax calculation. In the calendar year you exercise incentive stock options, the spread between the exercise price and the fair market value at exercise (multiplied the number of options exercised), is included in your income for calculating your tentative minimum tax.
This is the bargain element, and it’s not included when calculating your regular tax. The larger the bargain element, the more you may be subject to a significant AMT bill.
How Do You Calculate Alternative Minimum Tax?
The calculation of the tentative minimum tax is based on a nearly flat tax rate of 26% and 28% percent. For 2020, the first $197,900 of your income is taxed at 26% and any amount in excess of $197,900 is taxed at 28%.
The AMT rates at which income is taxed differently than regular tax law. How you calculate what counts as taxable income is different, too.
For example, you remove deductions for real estate tax and income tax as well as personal exemptions when calculating tentative minimum tax. While the bargain element isn’t included when calculating regular taxable income, it is included when determining whether or not you owe AMT.
Why Does the AMT Matter for Your Exercise of Incentive Stock Options?
The larger the value of the bargain element, the greater the potential for AMT. And of course, more AMT means a larger tax bill for you overall. Where will you get the cash to pay that bill?
This question is why AMT is so important to consider before you start playing with your stock options.
First, let’s understand how much cash you may need to foot your tax bill.
Say you have 10,000 incentive stock options with a grant price of $1 per share and an exercise price of $50 per share. You decide to exercise those options and hold the shares post-exercise. How much tax do you owe?
Here’s how this example breaks down:
- Cash needed to buy the shares at exercise: $10,000
- This is calculated by multiplying the number of shares exercised by the exercise price per share ($1 x 10,000)
- Cash needed to pay the tax at tax time (assuming a 28% flat AMT): $137,200
- This is calculated by multiplying the AMT rate by the fair market value at exercise less the exercise price X the number of shares: 28% x [($50 – $1) x Shares]
Most people don’t keep an extra $137,200 in cash lying around, freely available to spend on taxes. For many, paying this tax bill may not even be an option.
If you don’t have such an amount, you may be forced into other exercise strategies that create the required cash to cover both the exercise cost and the taxes that trigger.
And even if you do have that kind of cash available, you need to ask yourself: Do you want to use your cash to buy and hold shares?
If you do, you may be doubling down on your investment in the company stock by taking otherwise non-company stock assets and making them company stock. There are a lot of variables and factors to think through before taking any actions with your options.
This is why it’s important to have a comprehensive financial plan in place that takes both your finances and your potential taxes into account.
A Pre-Payment of Tax and the AMT Credit
One way to think about the AMT is to consider it a method the IRS uses to get you to pre-pay any potential tax you owe. Squaring up with the IRS on your pre-payment of AMT occurs when your exercised shares are subsequently sold.
Often, shares are sold in a qualifying disposition. A qualifying disposition occurs when the final sale of shares occurs at least 2 years from the grant date and at least 1 year from the exercise date.
Upon the final sale of shares (and assuming they are qualified), the total value 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 the 28% AMT prepayment and 15% long-term capital gains may be an overpayment of income tax.
Remember our example above where you ended up owing $137,200 in 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 qualifying disposition and subject to a tax rate of 15%, you’d owe $73,500. The difference between the AMT you paid and the tax required upon performing a qualified disposition is $63,700.
This amount, $63,700, is potentially available as a tax credit (the AMT credit, to be precise).
Unfortunately, the math behind how much you recover via the AMT credit is not as simple as advertised above. In fact, due to very complicated tax calculations, you may not be able to fully recover 100% of the AMT you pay (or it may take a very long time to do so), even if you perform a qualified disposition for all your shares.
What’s Next with Incentive Stock Options and the AMT
Understanding and interpreting the full scope of the AMT as it relates to incentive stock options is complicated. However, you can leave this article with a few key items in mind:
- You may owe AMT in the calendar year you exercise your stock options.
- The amount of AMT you’ll pay is related to the spread between the grant price and the exercise price of your stock options, multiplied by the number of shares you exercise.
- You may be able to get some of your AMT back in future years. But you may not get all of it back, or get it back as quickly as you hope.
Armed with this information, you can begin to ask questions regarding how you can avoid and/or limit AMT and how to implement incentive stock option exercise strategies.
Taking things one step further, you can complete a personalized tax projection with various assumptions for tax and growth rates can help you evaluate how much AMT you may pay under different strategies over the course of many years.
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.
Roy C. says
Great article Daniel. I really like examples to better understand concepts. The question I have is: How would the AMT exemption affect the amount to pay as AMT? I understand the 2020 AMT exemption for individual filers is $72,900, and for married joint filers, the figure is $113,400. Would that mean the AMT would have to be paid on $137.2k – 72.9k = 64.3, if I am filing individually?
Daniel Zajac, CFP®, AIF®, CLU® says
Thanks Roy, for the positive feedback.
The AMT exemption (or the portion you may be eligable to use) is actually subtracted from your Alternative Minimum Taxable Income (AMTI). AMTI a different tax calculation than the the one to figure your regular tax. You can learn more by checking out this article – https://www.danielzajac.com/what-you-should-know-about-the-alternative-minimum-tax/
Franz G says
Thank you, Daniel, for the good explanation about the impact of ISO on getting into the AMT bracket.
One item, though, is not clear to me – when do I have to pay the additional tax for exercising ISO stocks when I am hitting the AMT, right after I exercise the option, as a quarterly pre-payment, or when filing taxes?
Daniel Zajac, CFP®, AIF®, CLU® says
The tax is calculated and due by the tax filing deadline (commonly around April 15th of the following year). For example, an exercise and hold of ISO in 2020 is a reportable event on your 2020 tax returned, filed in 2021.
You can however, make estimated tax payments if you wish. You should consult with your CPA or other professionals to determine what the tax due may be, if you should make estimated tax payments.
steve witte says
I am looking for a software tool that I can use to estimate my 2020 tax liability. I have ISO stock options and RSUs and what to determine the impact of exercising/selling them.
Daniel Zajac, CFP®, AIF®, CLU® says
Hi Steve
If you are looking to do it on your own, the option I can think of right now is tax software. Stay tuned over here though!!!
PS – We might be able to help too.
Mike Anderson says
Would it make sense to exercise ISO’s before April 15th in a given year. So when the 1 year anniversary rolls around, you can sell the shares, to get the long-term capital gains treatment, to avoid having to pay the full AMT amount when filing taxes on April 15th of the following year?
Daniel Zajac, CFP®, AIF®, CLU® says
Hi Mike
Yes, this is a strategy that one might use to exercise and hold ISO. However, it’s not a strategy to avoid AMT. It’s a strategy to have cash available to pay for the AMT caused by the exercise and hold itself.
In your example, you may still owe AMT for the calendar year of the exercise and hold, but, you presumably have the cash proceeds from the sale of the stock that was exercised and held to cover the AMT “bill.” For the calendar year your sell the stock, assuming a qualified sale, you may have a long-term capital gain and a corresponding adjustment on your tax return for a potential AMT credit.
(all hypothetical of course, and any specific situation should be detailed accordingly)