If you have incentive stock options, you are likely familiar with the alternative minimum tax (AMT), and potentially the AMT credit. The AMT is a complicating factor that may rear its ugly head in a year that you exercise and hold incentive stock options.
A key feature of incentive stock options is that, if you do a qualifying disposition, you can claim long-term capital gains rates on the gain instead of at ordinary income rates. Because of this potential tax advantage, it may make sense to try and secure it.
But pursuing this strategy may leave you with a bigger tax bill than you expected thanks to the AMT. In fact, you might owe some amount in AMT in the year you exercise your incentive stock options even if you do not sell your shares.
When you do sell your incentive stock options shares, you will likely be taxed again on the sale of the stock. This can make it feel like you’re being taxed twice on the same income.
This is where the AMT credit comes into play. The AMT credit is in place to attempt to solve this problem so that you and the IRS can square up fairly on your tax bill.
The AMT credit also creates a tax planning opportunity.
When your sell your incentive stock option shares, keep in mind that not all shares are created equal — or at least, they don’t all have the same bargain element. Here’s why that matters, and how it creates an opportunity to accelerate tax credits.
Understanding What Drives the Amount You Pay in AMT
When you exercise and hold incentive stock options, you may be subject to the alternative minimum tax (AMT). This is because the difference between the exercise price of your options and the fair market value at exercise, known as the bargain element, is a tax preference item for the alternative minimum tax.
A large bargain element can make a big impact on how much you might own in AMT. In fact, the larger the bargain element, the larger the potential taxes due. This is why it’s so important to choose the right stock options to accelerate the amount of AMT credit coming back to you — but more on that in a moment.
Owing taxes can create a difficult problem if you want to exercise and hold your incentive stock options. It’s a cash flow issue, and the question is whether or not you have enough cash on hand to pay the AMT due.
Cash flow complications may be further complicated by the fact that if you exercise and hold incentive stock options with a cash exercise, you compound your cash outlay: you need to pay for the options with cash as well as have cash available to pay the AMT due.
(This potential negative cash flow in the year of exercise is why many people with incentive stock options may choose a cashless exercise instead of a cash exercise.)
How much in AMT will you owe, you ask? A very simplified way to estimate is by assuming a 28% tax rate on your bargain element.
Using a hypothetical example as an illustration, we can calculate the potential tax impact of exercising and holding incentive stock options. Let’s assume the following:
|Fair Market Value at Exercise||$50.00|
|Bargain Element at Exercise||$450,000|
|Tax Due (at 28%)||$126,000|
If you exercise and hold in the example above, you could owe $126,000 in AMT for the year you exercise.
The AMT Credit: How to Get Your Cash Back
It’s fair to ask why you’d ever pay AMT on incentive stock options when you can simply perform a disqualifying disposition and have the gain between the exercise price and fair market value at exercise be taxed as ordinary income.
The answer is that the AMT is a prepayment of expected taxes due. If you exercise and hold your shares until they qualify as a qualified disposition, then the entire gain, from exercise price to final sale price, may be taxed at long-term capital gains rates — which are more favorable than ordinary income rates.
And on top of that benefit, you can get some or all of the AMT paid back to you as a credit.
If you originally “prepaid” taxes at 28% and long-term capital gains rates are 15% when you perform a qualified disposition, you overpaid taxes by 13%, potentially leaving you eligible to get the overpayment of tax back. That’s the AMT credit opportunity.
Continuing the example above, if we assume the price of the stock remained constant for one year and the shares were sold as a qualified disposition, we can calculate you owe $67,500 in taxes (assuming a long-term capital gains rate):
|Fair Market Value at Exercise||$50.00|
|Fair Market Value Final Sale||$50.00|
|Long-Term Capital Gain||$450,000|
|Tax Due (at 15%)||$67,500|
Remember, you paid $126,000 in AMT when you exercised your incentive stock options. Once you sell these exercised options in a qualifying disposition, you get to “even up” on your taxes.
Since you actually owed $67,000 in this example but already paid $126,000, then we can suggest you overpaid by $58,500 ($126,000 minus $67,5000). This $58,500 is potentially available as a tax credit.
How to Maximize the AMT Credit by Exercising the “Right” Tranche
Now that we have a simple understanding of the taxation of incentive stock options, we can begin to use this understanding to accelerate AMT credits—specifically as it pertains to the final liquidation of incentive stock option shares.
From a practical standpoint, it’s not uncommon for an employee to have several tranches of incentive stock options. These tranches form as stock options are exercised at different points in time.
Often, these tranches have difference exercise prices, different fair market values at exercise prices, and different spreads between the two. These different prices may create a tax planning opportunity.
Let’s explore a hypothetical example (assuming all transactions will meet the standard for a qualifying disposition):
|Tranche||Exercise Price||FMV at Exercise||Final Sale Price||Bargain Element||AMT Tax (@28%)||LTCG (@15%)||Credit Opportunity|
If the goal is to maximize the tax credit available upon final sale, it may make sense to sell the tranche of options that included the highest AMT bargain element upon initial exercise. Or to put it another way, you might want to sell the tranche of shares that included the highest prepayment of taxes.
In our example, the highest prepayment of taxes is on the tranche of shares with the largest spread between the exercise price and the FMV at exercise. That’s the one with the highest bargain element.
Looking at the chart above, the tranche with the highest AMT impact upon exercise was likely tranche 1, where the exercise price is $5 and the FMV at exercise is $50. Using our same tax sample from above, tranche 1 has the opportunity to accelerate $58,500 in tax, as opposed to tranche 4, which will only accelerate $39,000.
The decision here is nearly a $20,000 difference.
Plan Strategically to Get More of Your AMT Credit Back, Faster?
It’s not uncommon for planning to occur on the front end of the decisions you make and actions you take around incentive stock options, specifically strategizing how and when to exercise.
But as you can see, the decision regarding which shares to sell on the back end is equally important.
In fact, depending on the value of your options and the bargain element, it’s very possible that selling the “right” tranches of stock may make the difference in accelerating a refund of thousands of dollars of taxes sooner rather than later.
Using the time value of money as our guide (a dollar today is worth more than a dollar tomorrow), it seems to make sense to want to accelerate cash back into our pockets as soon as possible.
Even further, a final sale of incentive stock options will create a cash inflow. What to do with the cash inflow created from liquidating concentrated equity is another massive decision in and of itself, but it creates an opportunity for you to leverage — if you plan appropriately and strategically.
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.
The content herein is for illustrative purposes only and does not attempt to predict actual results of any particular investment.