Daniel Zajac, CFP®

Incentive Stock Options and Executive Compensation

AMT

What You Should Know About the Alternative Minimum Tax

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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.

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.

How to Use the AMT Credit Effectively in Retirement

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If you have incentive stock options, you’ve likely heard of — and perhaps already paid — the alternative minimum tax. This is the tax due in the years you exercise and hold incentive stock options, or ISOs.

You might also be entitled to an AMT tax credit if that’s the case. The AMT credit gives you the ability to get back some or all of the AMT you paid when you sell your incentive stock option shares in a final sale.

Unfortunately, the AMT you pay and the AMT credit you might receive don’t always line up in a dollar-for-dollar offset.

If you sold your ISO shares, you may not have received the full AMT amount you paid in the form of a credit. Instead, you could have what’s known as a carryforward AMT credit.

A portion of the carryforward AMT credit will likely trickle back to you each year until the carryforward is fully exhausted, assuming you’re working and have wage income.

But what if you already retired and no longer have wage income to report?

Capturing the AMT credit can get more complicated in this case, and might warrant a change in your retirement income distribution strategy.

Here’s what you need to know.

A Review of One Retirement Income Distribution Strategy

“Where will my retirement income come from?” is a very common retirement planning question. Going from a reliable paycheck to an uncertain income stream is often a big hurdle for a new retiree to overcome.

While the process of distributing monthly income from investment accounts to mimic a paycheck is reasonably simple, the strategy behind the implementation isn’t always so straightforward.

One generally-accepted practice for taking retirement income is to distribute non-IRA money first, followed by tax deferred IRAs second, and Roth IRAs last.

This distribution technique is often an attempt to keep your income tax low and allow you to leverage tax-deferred growth for as long as possible. Some retirees can use distributions from a non-IRA so successfully that they don’t owe income tax at all — and that’s usually a good thing.

But depending on the particulars of your situation, it could also be a missed opportunity if you don’t “fill up” low income tax brackets by forcing taxable income from IRA distributions. The benefit of filling up low income tax brackets is the ability to take money out of taxable accounts a 0%, 10%, 15%, money that may otherwise be taxed at 20% or more if you take it out later.

This creative retirement income planning can be further complicated in your low taxable income retirement years if you also have a carry-forward AMT credit as the result of previously held incentive stock options.

If you have a carry-forward AMT credit, you likely need taxable income in order to get your AMT credit back– which means assuming you should follow the standard strategy and take your retirement income distributions from a non-IRA first, then an IRA second, then a ROTH IRA last might not be a good idea.

The Problem for the AMT Credit: Zero Taxable Income May Mean Zero AMT Credit

If you follow the standard process above and fund your retirement with distributions from a non-IRA account, you’ll likely need to sell investments within an account to create the necessary distributions.

When you sell investments, the amount that will be taxable will likely be equal to the difference between the cost basis (what you paid for the investments) and the final sale price (what you sell the investments for when you need to use the money).

Generally speaking, you will have one of the following outcomes:

  • If the cost basis is lower than the final sales price = reportable taxable income
  • If the cost basis is equal to the final sales price = no reportable income
  • If the cost basis that is greater than the final sales price = reportable capital loss

Whether you receive short- or long-term capital gains tax rates on the proceeds will affect the amount of taxes you pay, as well — and if you’re too good at creating (or limiting) taxable income that you generate zero taxable income, both your regular tax and your tentative minimum tax may also be zero.

The potential negative of zero taxable income is that there is no opportunity for an AMT credit that year. Because no income means no credit, you essentially defer the credit that may otherwise be due to you.

How to Force Taxable Income to Receive Your AMT Credit

How do you create taxable income during these low (reportable) income years — and more importantly, how do you know if it makes sense to do so?

One simple way to create taxable income is to take an IRA distribution. Generally speaking, an IRA distribution will be taxed as ordinary income in the year it is received.

Let’s look at an example of a single taxpaying using the standard deduction in 2019. Using Lacerte tax planning software, we know the total federal tax due if the only reportable income is  a $100,000 IRA distribution, is $15,253.

$15,253 is a lot of money. You may wonder why you would deliberately force this into taxable income if the other option is to pay no income tax at all.

For one thing, a 15% tax rate is relatively reasonable. For another, you may pay even less than $15,253 if you factor in what is owed to you through the carryforward AMT credit.

We can continue this example to illustrate when forcing taxable income might make sense. Let’s continue the assumptions we’ve worked with so far, and also assume you retired with $200,000 worth of carryforward AMT credit.

When you calculate your tax return, your regular tax will still be $15,253. You also have a tentative minimum tax (TMT) of $ $7,358, and this is the tax calculation used to determine if and when you get your AMT credit back.

If you have carryforward AMT credit and your TMT is lower than your regular tax, you may be eligible for the AMT tax credit.

In this example, the AMT credit will be the difference between the regular tax and tentative tax, or $7,895. Your taxes due in this situation is $15,253 of regular tax, less $7,895 of AMT credit — or $7,358. Your carryforward credit then adjusts to $200,000 less $7,895, or $192,105.

Because of your ability to leverage the AMT credit in this example, a $100,000 distribution of IRA assets cost only $7,358 in tax, or 7.36%.

What If You Don’t Need the IRA Money?

All this being said, you may not want to force IRA distributions, even if they are at a favorable 7.36% average tax rate, if you have non-IRA assets you can use to fund your retirement. There’s still a reason to consider making this move even in this case, though.

Creative planning, like using Roth conversions, may make sense in low-income retirement years. In lieu of taking the IRA distribution as cash to spend, you can process the distribution as a Roth conversion.

It would look like this:

  • You transfer $100,000 into a Roth IRA via a Roth conversion.
  • You report $100,000 of taxable income.
  • You pay tax on the $100,000 (assuming a 15% rate and the AMT credit, that’s $7,358).
  • The money in the Roth continues to grow tax-deferred and will eventually be income tax free (assuming certain conditions are met).

The Impact of 10 Years of Roth Conversions Coupled with the AMT Credit

We already looked at how to secure a low tax bill on a $100,000 distribution if you have an AMT credit and a $100,000 IRA distribution.

But that just illustrated a single year. This strategy might look even more appealing when you see the financial impact of forcing taxable income via a Roth conversion coupled with the capturing the AMT credit can have over a decade.

Assume that you process a Roth conversion of $100,000 per year for 10 years and the annual federal tax cost (per our example above) is only $7,358. Let’s also assume that the money in the newly established Roth IRA earns 7% per year.

Here’s what the numbers look like when you run them out over 10 years:

  • Total Income Taxes Paid: $73,580
  • Total AMT Credit Used: $78,950
  • Remaining AMT Credit: $121,050
  • Future Roth IRA Value: $1,478,360

If you know how to use your AMT credit effectively in retirement, you can create a tax-deferred and income tax free bucket of nearly 1.5 million dollars at a tax “cost” of just $73,580.

The fact that Roth IRAs are not RMD eligible makes this an even better deal.  You took $1.5 million of IRA dollars that would be subject to RMDs and moved them into an account that is RMD-free.

Using the AMT Credit in Retirement

Retirement income planning can be complicated in even the simplest scenario. It gets even more complicated when you add advanced tax planning and the AMT credit. But that complication may lead to opportunity for those versed with the knowledge.

If you transition into retirement with potentially low-income tax years and a carryforward AMT credit, it may be overly simplified to assume you should take distributions from a non-IRA first, then an IRA second, then a Roth IRA last.

If you follow this shortsighted track, you may be missing the opportunity to effectively utilize your AMT credit in the short and long term in a meaningful way.

By completing a bit of advanced tax, investment, and cash flow planning, you can develop a strategy that effectively accelerates some of your AMT credit sooner rather than later, and allows you to effectively reallocate your assets in a more tax efficient manner.

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.

Why Waiting to Exercise Your Incentive Stock Options May Increase The Alternative Minimum Tax

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Incentive stock options are unique in that the longer you wait to exercise, the costlier it may be to exercise and hold your shares. That’s not because exercising the incentive stock option cost more, as that price is fixed, but because the cost of the alternative minimum tax (AMT) may be higher.

One concern with a costlier alternative minimum tax is that it may put additional pressure on personal cash flows to pay that pending tax bill.

The larger the difference between the exercise price and the fair market value of the stock (commonly known as the bargain element), the more alternative minimum tax you may owe.

So while most of us want the share price of our stock to increase over time, and getting preferential tax treatment is always nice, too, incentive stock options may complicate the situation creating a scenario that increases the amount of the alternative minimum tax, quite possibly making it more difficult (costly) to achieve the qualifying disposition which leads to that better tax treatment, as the stock price rises.

This leads to a common question; does it make sense to exercise your incentive stock option shares earlier in an effort to minimize the alternative minimum tax?

It may – however, that strategy is not without other risk.  Lets explore.

 A Tangible Example of the Cost of Waiting

Let’s assume that your exercise price of 10,000 incentive stock options is $1 per share and the current share price is $10 per share. The current value of your incentive stock option is $90,000.

If the share price increases from $10 per share to $50 per share, the value of your incentive stock option grant will be $490,000.

Number of ISO’s Exercise Price Hypothetical Share Price Value
10,000 $1.00 $10.00 $90,000
10,000 $1.00 $50.00 $490,000

A higher stock price is a good thing because it means that your incentive stock options are worth more. What may not be so obvious, however, is that your AMT bill likely increases as the value of the unexercised incentive stock options increases.

But it’s not all bad news. By understanding how a growing stock price impacts the AMT, you may be able to strategically plan a sound exercise strategy.

Let’s explore what happens when you exercise your incentive stock options, how your incentive stock options are impacted if you wait, and why you may want to reconsider your overall strategy.

What Happens When You Exercise Your Incentive Stock Options?

When you exercise your incentive stock options, the difference between the exercise price of the incentive stock option and the share price of the stock when you exercise, multiplied by the number of shares exercised, is a reportable event for calculating the alternative minimum tax.

For our illustrations, let’s assume a 28% flat AMT rate.

Following the example above, if you exercise and hold your incentive stock options, you will incur the following AMT.

Number of ISO’s Exercise Price Hypothetical Share Price Value AMT (28%)
10,000 $1.00 $10.00 $90,000 $25,200
10,000 $1.00 $50.00 $490,000 $137,200

As the value of the share price increases from $10 per share to $50 per share, the value of your ISO grant increases from $90,000 to $490,000. What also increases is the amount of AMT you will pay if you exercise and hold the ISO shares (from $25,200 to $137,200).

Why a Higher Alternative Minimum Tax May Be an Issue

It’s possible that a higher AMT may not be a problem for everyone. It can be viewed as the byproduct of an increasing stock price that generates greater and greater wealth. And if you can manage the cash flow and investment risk of an exercise and hold, it may make sense to do so.

But one area where things might be problematic is if you’re tax-averse. If you are, a significant tax bill via an exercise and hold of incentive stock options may be enough to cause you not to exercise – (even if exercising may be in your best interest).

By not exercising, you retain your potentially volatile equity position in one stock (a position that can be good or bad based on the future stock price movements) and you do not begin the holding period for a qualifying disposition.

Another potential issue might be generating cash to cover the AMT bill. If you want to exercise and hold your incentive stock options but don’t have the cash on hand to cover the pending tax bill, you might feel stuck.

Using the example above, you’d need to come up with $137,200 to pay the alternative minimum tax. Not everyone has that cash lying around available to send to the IRS.

One potential solution to the cash flow issue might be to exercise and sell some of your incentive stock options right away, using the profit generated from the exercise and sale to pay a pending tax bill.

When Alternative Minimum Tax is an Issue — But Not an Issue

Regardless of a higher alternative minimum tax and the potential issues above, it’s important to note that a rising stock price and a rising alternative minimum tax bill (all else being equal) may still be a good thing.

Your after-tax value when the share price is $50 per share is significantly higher than it is when a share price of $10 per share.

Number of ISO’s Exercise Price Hypothetical Share Price Value AMT (28%) After-Tax Value
10,000 $1.00 $10.00 $90,000 $25,200 $64,800
10,000 $1.00 $50.00 $490,000 $137,200 $352,800

A higher stock price might require a higher AMT or a bigger cash call. But all else being equal, this is a good problem to have as compared to ending up with a lower stock price.

What If You Exercise Your Incentive Stock Options Early?

One difficult part of an exercise and hold is determining whether or not your bullish call on the stock — your assumption that the price will rise over time — is right or wrong. It may be easy to be bullish on a stock you didn’t put any of your own money into; it’s another thing to exercise and hold, funding this with other personal assets that you are now at risk of losing, and retaining that bullish mentality.

If you can get over the risk of loss associated with exercising and holding your shares, and couple this with your bullish prognostication, you may have an argument to exercise early and hold your shares over time.

For example, if the current market value is $10 and you expect the future share price to be $50, it may make sense to exercise now when the AMT is lower (only $25,200) instead of waiting to exercise later when the AMT is higher ($137,200 at a $50 share price).

By exercising early, you lower the total AMT you owe, which also limits the required cash you need to cover that bill. You also get the benefit of beginning your holding period requirements for a qualifying disposition.

How Your Financial Plan May Impact Your Decision Making

A good financial plan will likely consider when you will want to sell your incentive stock options and redirect the proceeds elsewhere. One common time for people is retirement, assuming that you have generated enough wealth to meet your financial needs for the rest of your life.

A second consideration may be a stated share price, or a stated total value of the stock options, when you are of the belief that the stock price if “fair” and you want to take your profits and run.

If you project yourself wanting to sell your incentive stock options for either reason, waiting to exercise your incentive stock options might or might not be the right strategy.

Here is the potential issue: If you exercise your incentive stock options on the same day that you reach the point you want to sell them, you may not be able to sell and obtain preferential tax treatment.  To obtain the preferential tax treatment, you will need to hold them for a full year past the date you exercise.  This leaves you exposed to the risk of your stock losing value, and ending up short of the wealth you need to meet your goals.

If you have incentive stock options and you meet the standard for a qualifying disposition, your realized gain from the exercise price to the final sales price will be taxed as a long-term capital gain. To obtain this tax treatment, you will need to hold your exercised incentive stock option shares for at least one year past the date of exercise prior to selling them.

Let’s assume that, based on your calculations, achieving a qualifying disposition with a share price is $50 per share will give you enough value to meet your goals.

If you exercise and sell immediately, you will not achieve a qualifying disposition. This may mean your tax bill will be higher than preferential long-term capital gains rates, and your proceeds will be less than what you need to fund your goals.  This is not to say a disqualifying disposition is a bad outcome.  In fact, it may be the right decision in some scenarios.

If, however, you retain the shares in an attempt to obtain the preferential tax treatment, you will be subject to the market fluctuations for at least one year. And who knows what the price will be then?

Number of ISO’s Exercise Price Hypothetical Share Price Value AMT (28%) After-Tax Value Share price in 1 year
10,000 $1.00 $10.00 $90,000 $25,200 $64,800 ???
10,000 $1.00 $50.00 $490,000 $137,200 $352,800 ???

 

Clearly there is a timing issue between planning when you need the proceeds of your incentive stock options, what you have to do to obtain a qualifying disposition, and how the share price performs (the ultimate unknown).

What Does This Mean for Exercise and Holding Your Incentive Stock Options?

If you are bullish on the company and you plan on holding your shares for at least an additional year, it may make sense to consider an earlier exercise of your incentive stock options.

In doing an early exercise, you may achieve the following:

  1. You start your holding period requirement to meet the standard for a qualifying disposition.
  2. Assuming the share price is higher when you sell then when you exercised your incentive stock options, you may pay less alternative minimum tax.
  3. You may create additional liquidity options for your stock that may be more tax beneficial than the alternatives.

While the potential benefits are many, there are also risks to consider.  Namely you may be wrong and the stock price may drop. If you exercise and hold your shares, this may leave you at risk of losing real money.

Ultimately the decision to do an early exercise should be based on your goals, your risk, and your intentions for the stock in the short and long term. A good plan will address these questions at both a global level as well as an individual stock grant level.

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.

4 Taxes to Plan for When You Sell Your Incentive Stock Options

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If you try and look up information to learn more about your incentive stock options, most of what you’ll find addresses what happens when you exercise your options — but doesn’t go much farther than that.

You may already know that when you exercise your incentive stock options, or ISOs, the value of the bargain element impacts whether or not you will pay alternative minimum tax (or AMT).

But what you may not know is how much AMT you will need to pay, how to strategize for this, and when the tax will be due. This uncertainty may lead you to wonder when exactly you should exercise, and if you do so, whether you should hold or sell.

Understanding the potential tax when you exercise your ISOs is an important factor to consider (and this article can help you determine the right move in your situation). But asking questions about taxes at exercise is not the only time you need to think about what you could owe.

You need to think about taxes when you sell your incentive stock options shares, too. There are several types of tax that may influence how many incentive stock option shares you sell, when, and how much tax you pay on those shares.

These taxes include:

  1. The AMT credit
  2. Capital gains taxes
  3. The net investment income tax (NIIT)
  4. The AMT phase out tax.

If you understand the taxes and how to calculate them, you may be able to save thousands of dollars in tax with proper planning for the sale of your incentive stock options.

Here’s what to know and consider.

Incentive Stock Options and the AMT Credit

When your sell your previously exercised and held incentive stock options, you may receive an AMT credit.

An AMT credit occurs when your tentative minimum tax is lower than your regular tax. When you sell your ISO shares, you undo what caused you to pay AMT in the first place: the bargain element.

When you undo the bargain element, you “square up” tax with the IRS.

More specifically, selling ISOs shares is a negative adjustment to your tentative minimum taxable income. A negative adjustment may result in a greater spread between your tentative minimum tax and your regular tax, and that means a greater opportunity for an AMT credit.

A planning opportunity for the AMT credit arises if you have multiple lots of previously held ISOs. If you do, it may make sense to strategically sell a specific lot of stock options to accelerate your AMT credit.

Look at the bargain element paid when you exercised your ISOs. An exercise that had a larger bargain element when you exercised may have created a larger AMT than an exercise that had a smaller bargain element.

Given that, it makes sense that undoing the ISO exercise that caused the larger AMT might also create largest opportunity for an AMT credit.

The AMT credit gets a lot of attention on the sell-side of ISO shares because it can help drive down your tax bill in the year you sell your incentive stock options. But again, it’s not the only tax to consider.

Incentive Stock Options and Capital Gains Taxes

Capital gains tax is a tax paid on the gain when you sell certain types of property. This includes employee stock and stock options. The tax is levied on the profit you make only when you sell you stock, not during the period you hold the stock.

Assuming you sell your incentive stock options as a qualifying disposition, the realized gain from the grant price to the final sales price will be taxed as a long-term capital gain.

For 2018, long term capital gains are subject to either a 0%, 15%, or 20% tax rate depending on your adjusted gross income and your filing status. Specifically, the rates are as follows:

Long-Term Capital Gains Tax Rate Single Married Filing Jointly
0% $0-$38,700 $0-$77,400
15% $38,700-$426,700 $77,400-$480,050
20% $426,700 or more $480,050 or more

 

When planning to sell your ISO shares, it’s important to know these tax breakpoints. For example, let’s assume the following:

  • You are 60 years old
  • You file Married Filing Jointly
  • You have no other income or deductions or previous tax credits

In this situation, you could sell enough shares to generate up to $77,400 of long-term capital gains and pay zero income tax. All of the profit from the sale would be in the 0% tax bracket.

If you exceeded $77,400 of capital gain, you’d be in the 15% income tax bracket. Every long-term capital gain dollar from $77,401 to $480,050 would get taxed at 15%, and long term capital gains over $480,050 would be taxed at 20%.

Once you know this information, you can use it for good tax planning when you sell your incentive stock options. Let’s assume it’s getting close to the end of the year and you have $500,000 of unrealized profit in your incentive stock options that meet the qualifying disposition standard.

Option 1 is to sell the shares all in 1 year. Option 2 is to spread the exercise over 2 years. Assuming you choose option 1 and capture $500,000 of long-term capital gain, here’s how you’d be taxed:

Tax Rate Year 1 LTCG Year 1 Tax
0% $77,400 0
15% $402,650 $60,398
20% $19,950 $3,990
Total Tax $64,388

 

Option 2 might be the better answer here because you sell over 2 calendar years. Assuming  your following calendar year tax return looks the same in terms of income and deductions, you could “defer” $77,400 of gain to the next year to “fill up” the income allowed to be taxed at 0% tax year 2 of the plan.

This removes your profit from the sale of ISO shares from being subjected to the 15% and 20% tax brackets and placing it into the 0% tax bracket instead.

Your taxes could look like this:

Year 1 LTCG Year 1 Tax Year 2 LTCG Year 2 Tax
0% $77,400 0 $77,400 $0
15% $345,200 $51,780 $0 $0
20% $0 $0 $0 $0
Total Tax $51,780 $0

 

In Option 2, the total tax over the 2 years is $51,780 — almost $13,000 less than Option 1.

While the risk of holding stock for a longer period may or may not be worth the potential tax savings, a nearly 20% reduction in the tax you pay may be something to consider.

As always, individual tax scenarios are specific and should be tested accordingly. But this example highlights the valuable planning opportunities around the capital gains tax.

Incentive Stock Options and the Net Investment Income Tax (NIIT)

The NIIT is an additional tax that is levied on investment income if your income exceeds certain breakpoints. The tax is 3.8% on investment income in excess of $250,000 (if you file Married Filing Jointly) and $200,000 (if you file single).

If you follow the capital gains rules above, you will see there are two breakpoints that may impact your tax and financial planning: an adjusted gross income of $77,400, and again for an AGI of $480,050 (assuming you file as Married Filing Jointly).

The NIIT adds yet another breakpoint at $250,000. If you sell ISO shares and realize capital gains that exceed $250,000, you’d increase your total tax on profit from the sale of ISOs from 15% to 18.8%.

Continuing our example from above, we could assume you want to exercise enough shares to generate just enough gain to reach the 15% long-term capital gains rates. If you’re not aware of the NIIT, you might assume you’d pay 15% tax on the profit between $77,400 and $480,050.

Specifically, this is equal to:

($480,050 – $77,400) x 15%

= $60,398

However, because of the NIIT, the actual amount of tax you pay will be higher. In addition to the tax above, you will also pay NIIT on the profit in excess of $250,000:

(Long-Term Capital Gain – Threshold Amount) x NIIT Rate

($480,050 – $250,000) x 3.8%

= $8,742

If you add these two together, your total tax bill comes to $69,140.  While the tax saving of 3.8% if you spread the sale over multiple years may be small, it still is worth paying attention to.

In addition, if you sold your ISO shares and that caused your income to exceed the 20% breakpoint of $480,050, you’d actually owe 20% + 3.8%, or 23.8%, in total taxes.

Incentive Stock Options and the AMT “Phase Out Tax”

The AMT uses a second set of tax calculations that include the bargain element, limiting deductions, and different tax rates (26% and 28%) to determine if you owe income tax.

The rules for AMT also have an exemption amount and phaseout that are different from the regular tax calculation. For calculation the AMT, the exemption and phase out period is as follows:

2018 Exemption 2018 Phase Out (AMTI)
Single $70,300 $500,000
Married File Joint $109,400 $1,000,000

When your alternative minimum taxable income (AMTI) exceeds $1,000,000, you begin to lose your exemption at a rate of $0.25 per $1.00.

Let’s assume that you file as Married Filing Jointly and you have an AMTI of $1,250,000. Since your AMTI exceeds $1,000,000, you need to reduce your exemption by 25 cents on the dollar.

Said another way, for each $4 of income you need to reduce the exemption by $1. To calculate, we can do the following:

(1,250,000 – $1,000,000) / 4

= $62,500

If your exemption is $109,400 and you reduce it by $62,500, your exemption is limited to $46,900.

The net result of a lower exemption is a higher AMTI. A higher AMTI means that more of your money will be subject to tax, leading to a greater amount of tax due.

If your entire AMTI is taxed at 28%, we can take the example above to illustrate the tax impact by comparing a scenario with a full exemption vs. a scenario with a reduced exemption:

If Full Exemption Reduced Exemption
AMTI $1,250,000 $1,250,000
Married File Joint $109,400 $46,900
Taxable Amount $1,140,600

 

 $1,203,100
At 28% $319,368 $336,868

In the reduced exemption scenario, you are subject to $17,500 more tax due to the fact you exceeded the phaseout over $1,000,000 by $250,000. In other words, you paid an additional 7% “phase out tax” ($250,000 / $17,500).

When your AMIT reaches $1,437,600, your phase out reaches $0. At this point, there is no additional “phase out tax” on income that exceeds this amount.

What Does This Mean for You When Selling ISO Shares?

When your sell your incentive stock options shares in a qualifying disposition, you should pay attention to AMT credits, long-term capital gains, the NIIT, and the phaseout tax.

By knowing when you reach breakpoints that require you pay more tax, you can plan up to and around them. Doing so could save you thousands of dollars on your tax bill.

Unfortunately, this planning is not easy to do. You need to have a solid understanding of both the calculation for the regular tax and the alternative minimum tax. You should also pay attention to different lots of ISO shares and how they may or may not accelerate your AMT tax credit.

You also need to do all this tax planning as you consider investment planning. As you make these decisions around taxes, you can’t forget to think about investment risk, concentration risk, and your targeted financial goals that must be part of the overall plan.

If you find yourself overwhelmed by the process, it may make sense to work with someone who help answer all of these questions for you in a cohesive plan.

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.  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.

How and When Are Incentive Stock Options Taxable?

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Incentive stock options are a form of employee compensation that allows you to participate in the appreciating value of a company stock price.

Similar to non-qualified stock options, incentive stock options (ISOs) allow for the purchase of a stock at a predetermined share price. If the current share price of the stock is above the price at which you can exercise your right to buy the share, you have an “in the money” option.

But if the current market price of the stock is below the price at which you can buy the share, you likely pass on your right to exercise the option and buy the shares.

If you find yourself with ISOs, it will be helpful to have a working knowledge of how this type of equity compensation is taxed.

Generally speaking, ISOs aren’t taxed until you exercise the option to buy the share – but over the lifespan of an incentive stock option, you may find yourself dealing with several types of taxes along the way.

Taxes on Incentive Stock Options When You Exercise

The first taxable event occurs when you exercise your ISOs. When you exercise your incentive stock options, you create a reportable tax event that is based on the spread between the grant price of the option and the fair market value of the stock when you exercise, multiplied by the numbers of shares you exercise.

For example, let’s assume you have the following:

  • 10,000 ISOs
  • $1.00 grant price
  • $25.00 fair market value at exercise

In this example, the $24 spread between the grant price and the fair market value at exercise X 10,000 shares is $240,000.

This amount is known as the bargain element. The type of tax you may pay on the bargain element depends on what you do next.

The Difference Between Qualifying vs. Disqualifying Disposition of Incentive Stock Options

Incentive stock options are often preferred to non-qualified stock options because you have the potential to pay long term capital gains rates on the bargain element of the stock should you meet specific holding requirements:

  1. The final sale of the stock must be at least 2 years from the grant date, AND
  2. The final sale of the stock must be at least 1 year from the exercise date.

Should you meet these requirements, the bargain element and future gain gets taxed at preferential rates. This is known as a qualifying disposition.

If you don’t meet the requirements you have a disqualifying disposition and the bargain element will be taxed as ordinary income. It won’t be subject to Social Security and Medicare wage tax (I point this out as a difference between NSOs and ISOs. NSOs are subject to Social Security and Medicare wage tax).

Tax on a Disqualifying Disposition of Incentive Stock Options

Let’s assume you immediately exercise and sell the shares from our hypothetical example above. In this scenario, you turned stock options into cash you can use for personal expenses or allocate to savings.

The rules of a disqualifying disposition state that the bargain element will be treated as ordinary income. If we assume a flat 35% tax bracket, we can assume you will pay $84,000 in tax on your exercise and sell of $240,000 worth of incentive stock options.

Tax on a Qualifying Disposition of Incentive Stock Options

Continuing the above example and assuming you exercise and then hold your ISOs, the tax implications become increasingly more complicated. You may be subject to the alternative minimum tax, or AMT, and long-term capital gains rates (assuming you have a gain when you sell).

AMT is the result of a secondary tax calculation that occurs every year when you file your tax return. As a taxpayer, you generally pay the higher of the regular tax calculation or the tentative minimum tax calculation. The difference you pay if the tentative minimum tax is higher is the AMT.

When you exercise and hold incentive stock options pas the calendar year end, no earned income is reported on your W2. Your adjusted gross income on your regular tax calculation won’t change.

But the bargain element is a tax preference item for calculating the tentative minimum tax. This means that if you exercise and hold incentive stock options, it’s possible that this tentative minimum tax calculation may be the higher of the two. If it is, you’re required to pay that amount instead.

Following the example above, let’s assume the same situation and an AMT tax rate of 28%:

  • 10,000 ISOs
  • $1.00 grant price
  • $25.00 fair market value at exercise

In this scenario, the $240,000 of bargain element will result in a tentative minimum tax of $67,200.

If your tentative minimum tax is higher than your regular tax, you will owe the higher of the two. Tentative minimum tax being the higher of the two is often a direct result of the exercise of ISOs.

Eventually, you’ll probably sell the ISOs you exercised and held. If you sell your shares as a qualifying disposition, you’ll pay long-term capital gains on the entire amount from the original grant price of the stock to the final sales price.

Continuing our example from above, let’s assume that since you exercised the shares, the share price has increased from $25 per share to $65 per share.

  • 10,000 ISOs
  • $1.00 grant price
  • $25.00 fair market value at exercise
  • $65.00 final sale price

Assuming a qualifying disposition, the entire amount from $1 per share to $65 per share should be taxed at long-term capital gains rates. This gain is $640,000. Assuming a flat 15% tax bracket, you will be subject to $96,000 in capital gains tax.

Alternative Minimum Tax Credits

If you are following the above scenario, you may have noticed that you have in fact paid tax twice on a certain portion of the hypothetical example:

  1. You paid the AMT on the amount between $1 and $25 when you exercised and held and
  2. You paid LTCG on the amount between $1 and $25 when you sold the shares

Clearly, this would be a disadvantageous tax scenario. Enter the AMT credit.

When you sell your incentive stock option shares in a final sale, you “undo” the original bargain element that caused you to pay AMT. This “undoing” on your tax return is addressed by figuring regular capital gains and AMT capital gains.  This calculation may allow you to receive an AMT credit to cover the tax you already paid.

Said another way, when you sell your shares, you may get some or all of the money you paid on AMT when you exercised and held back to you.

This explains why much of the attention surrounding incentive stock options centers around AMT. A significant AMT bill may be a reason (or not) to exercise your shares. It should certainly be a reason to consider what your options strategy may be.

Other Advanced Tax Considerations to Remember

In addition to AMT, you may want to think about long-term capital gains. Long-term capital gains may be taxed as low as 0% — or they could be taxed at 15%, or even as high at 20% when your income exceeds $496,600 (married filing jointly in 2020).

When planning for your final sale of stock, it is important to understand what other income you have and how much room you have in various capital gains tax brackets.

For example, one strategy may be to “fill up” your 15% capital gains tax bracket. You can run detailed tax projections to determine how much capital gains you can incur, therefore determining how much stock you can sell, so you only pay 15% capital gains tax.

To do this calculation well, it may take the resources of a good accountant or financial advisor. When considering you could pay far less in tax by getting these complicated decisions correct, it may be well worth hiring a professional to help you.

You may also need to deal with the net investment income tax (NIIT). This tax is paid on capital assets (which are likely the shares of company stock you sell) when your adjusted gross income exceeds $250,000 (for married filing jointly in 2020).

The amount in excess of $250,000 is taxed at 3.8%. If we combine the NIIT with the highest capital gains bracket above (20% + 3.8%), you can see that your long-term capital gains may be taxed as high as 23.8%.

And while not exactly a direct tax in the same sense as long-term capital gains and net investment income tax, you should still pay attention to how AMT is calculated and how it impacts how much tax you pay.

What to Know About Tax and Incentive Stock Options

You may face many different types of taxes owed when you have incentive stock options. The timing of your exercise, hold, and final sale of the stock options can only further intensify the difficulty in understanding which of those taxes apply and what moves to make to reduce your bill.

Unfortunately, this complexity and uncertainty often leads to inaction because people feel afraid of the unknown — or they’re afraid of making a mistake.

If you find yourself with incentive stock options, begin learning about the tax you may pay and when. If you are not prepared to handle that on your own, it may make sense to work with someone who is an expert in tax and other financial planning needs that can arise.

Knowing the rules and planning a good exercise strategy for your incentive stock options can lead to a material difference in the amount you receive in the end.

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.

The hypothetical examples included are for illustrative purposes only and do not attempt to predict actual results of any particular investment.

How to Do a Year End Exercise of Incentive Stock Options to the AMT Crossover Point

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Finding the best time and best strategy to exercise incentive stock options is difficult. Competing considerations on income tax, investment planning, and financial planning make it difficult to address the best time to exercise incentive stock options (ISOs) with a blanket answer.

Some strategies suggest that exercising early may be a good idea, because this is when the impact from the alternative minimum tax, or AMT, may be lowest. Others suggest it’s best to exercise as late as you can. Waiting offers you certainty as to final value of the stock options, and your incentive stock options become a use it (exercise) or lose it (the stock option expires) situation.

Exercising early or exercising late aren’t your only two options. Instead, you might want to consider a year-end exercise to maximize the bargain element up to your regular tax base.

The 2017 tax law change made this particular strategy even more appealing. Why? Because most people want to do everything they can to avoid the AMT, including not exercising options so as not to trigger the tax.

But a year-end exercise up to the AMT crossover point strategy might provide you with a way to “have your cake and eat it too.”

With good planning, you can exercise a specific number of ISOs prior to calendar year end without incurring any AMT. In addition, this strategy begins the holding period to obtain a qualifying disposition.

Unfortunately, the details of this implementing a year end exercise up to the AMT crossover point may get a little confusing. Let’s walk through them together.

Changes in the Way Alternative Minimum Tax is Calculated Due to the 2017 Jobs Tax Act

The year-end exercise to the AMT crossover strategy has always been an option if you have incentive stock options and good tax planning skills. The 2017 Jobs Tax Act expanded that opportunity because it changed the way AMT will be calculated in 2018 and beyond.

The 2017 Jobs Tax Act made changes to increase exemptions and increase when phaseouts of said exemptions occur when calculating AMT. This is all a fancy way of saying that it is likely less people will be subject to AMT in 2018 and beyond.

Moving into 2019 and 2020, key figures for the exemption and phaseout are as follows:

2019 Exemption 2020 Exemption 2019 Phaseout 2020 Phaseout
Single $71,700 $72,900 $510,300 $518,400
Married File Joint $111,700 $113,400 $1,020,600 $1,036,800

For those with ISOs, a byproduct of the 2017 Jobs Tax Act may have created an opportunity for a larger AMT free exercise of incentive stock options than previously eligible.

Before we dig into a hypothetical example, let’s recap what we should already know about ISOs and the AMT.

Incentive Stock Options and the AMT

When you exercise and hold incentive stock options, you likely do so with the hope of obtaining a qualifying disposition. A qualifying disposition is one when the final sale of the stock occurs at least 2 years from the grant of the incentive stock option, and one year from the exercise date of the option.

The net result of a qualifying disposition is that the entire value from the grant price to the final sales price is treated as a long-term capital gain (assuming there is a gain in value).

What complicates this seemingly simple strategy is the AMT. AMT is based on a secondary tax calculation that occurs every year you file a tax return known as the tentative minimum tax.

As a taxpayer, you pay the higher of the regular tax calculation and the tentative minimum tax. AMT is what you pay when the tentative minimum tax is higher than the regular tax.

When you exercise and hold incentive stock options, the bargain element (the difference between the grant price and the exercise price multiplied by the number of shares exercised) is included in the calculation of the tentative minimum tax. That often makes the tentative minimum tax the higher of the two calculations, leaving you on the hook for paying AMT.

What matters when exercising ISOs up to the AMT crossover point is the spread between the two calculations. The smaller the spread between the two, the smaller the opportunity. The greater the spread, the greater the opportunity.

All else being equal, the 2017 Jobs Tax Act increased the spread between the two. This means you can likely exercise more of the bargain element than previously allowed, which leads to a greater planning opportunity.

AMT Crossover Example when Exercising Incentive Stock Options           

Using a hypothetical example, we can illustrate how to exercise and hold ISOs up to the AMT crossover point.

We will use a simple tax return with a few assumptions for our illustration:

  1. Our taxpayers are married couple and both spouses are 55; no kids
  2. They file as Married Filing Jointly on their tax returns
  3. They earn $250,000 of gross annual income
  4. They take the standard deduction

A Hypothetical Tax Analysis

When we plug the above information into a hypothetical tax return, we can calculate two key numbers: regular tax and the tentative minimum tax.

Simplifying a return, we see the following:

Regular Tax   Tentative Minimum Tax
Total Income 250,000 Alt Min Taxable Income $250,000
Taxable Income 226,000 AMTI Less Exemption $138,300
Regular Tax (20%) $45,200 AMT (26%) $35,958

As you can see, the regular tax is $45,200 and the tentative minimum tax is $35,958.  As the regular tax is the higher of the two calculations, this household will be required to the pay $45,200 in tax.

When planning a year end exercise strategy, you want to review the spread between the two calculations. In this scenario, the spread is $9,042.

At this point, we need to ask:

  1. How many incentive stock options can you exercise and still have the regular tax calculation be the higher of the two?
  2. How much of the bargain element (the difference between the grant price and the exercise price multiplied by the number of shares exercised) can you incur until you reach the AMT crossover point?

A simplified calculation may be as clean as dividing the spread by 26% (26% is being used as our AMT tax rate)

($45,200 – $35,958) / 0.26 = $34,777

In this simple calculation, these taxpayers could exercise and hold $34,777 of the bargain element and still pay no AMT.

If we wanted to be exact in our calculation, it would be necessary to go back to actual tax software to project the return.  If your tentative minimum tax is higher than your regular tax, you may be able to modify by lowering the bargain element.  Alternatively, if your tentative minimum is below the regular tax, you may be able to capture more bargain element.

Applying These Examples to Your Incentive Stock Option Grants

Once you know the amount of the bargain element you can capture, you can circle back to your incentive stock option grants to determine how many options you can exercise. Let’s assume you have the following grants:

Shares Grant Price Exercise Price Bargain Element
Grant 1 10,000 $1.00 $25.00 $240,000
Grant 2 10,000 $5.00 $25.00 $200,000

As you can see from the line on the right, if you exercised all of the grants above, you incur $440,000 from the bargain element. But the goal is to exercise only enough to reach the crossover point.

To do so, we need to calculate how many shares you could exercise to reach $34,777 worth of the bargain element for 2018.

If we assume that you exercise shares from Grant 1, the math is as follows:

“Shares to Exercise” X (Exercise Price – Grant Price) = Intended Bargain Element

“Shares to Exercise” X ($25 – $1) = $34,777

“Shares to Exercise” = 1,449 (rounded down)

If we assume that you exercise shares from Grant 2, the math is as follows:

“Shares to Exercise” X ($25 – $5) = $34,777

“Shares to Exercise” = 1,738 (rounded down)

While you can exercise more shares if you are do exercise grant 2, you may also want to pay attention to the cash flow required to do so.  When you exercise your ISOs, you will need to pay for the shares.  The cost of each exercise is:

Shares Exercised X Exercise Price

Grant 1 Cost = 1,449 X $1 = $1,449

Grant 2 Cost = 1,738 X 5 = $8,690

In this example, the cost of Grant two is materially higher than the cost of grant 1.  A full decision about AMT crossover should include the cost of the AMT as well as the cost of exercising and holding said shares.

The Benefits of This Incentive Stock Exercise Strategy

If you followed the details of the above analysis, you might notice you don’t actually save income tax in the year you exercise up to the AMT crossover point. So what, if any, value does this complicated strategy have?

The first benefit is a future tax savings opportunity. If you implement this strategy correctly, you will not pay AMT (or you will pay limited AMT) on the exercised ISOs. If you do not implement this strategy, it is reasonable to assume that you’ll exercise your ISOs in a year when you are subject to AMT.

For example, in lieu of exercising some shares each year, you might exercise an entire grant of shares in 1 year. If we assume this is true, we can also assume that the ISOs will be subject to AMT in future. If they are, they will be taxed at the requisite 28% (or the appropriate AMT rate at that time).

If we compare exercising ISOs at zero cost today versus 28% later, we have a clear winner.  The tax savings opportunity is 28% in opportunity cost.

(To be fair, some or all of the 28% AMT you pay may come back to you as an AMT credit in future tax years. In this sense, it’s not a total 28% savings. On the other hand, AMT also may cause a cash call need that you could avoid with the AMT crossover strategy).

The second benefit of this strategy is that it starts the holding period for a qualifying disposition of some of your shares. This means that after 1 year from exercise, you will have a portion of your shares that are eligible to be solid in a preferential tax treatment via qualifying disposition.  This creates liquidity that you may not have otherwise had.

For example, imagine that you need $X amount of dollars but did not follow the above strategy. To get that money, you’d likely need to do a disqualifying disposition of ISOs, meaning a higher tax bill as you wouldn’t meet the requisite holding periods (assuming you cannot go somewhere else for the money).

A third benefit is the cumulative effect of this annual exercise strategy. In our example, you can exercise $34,777 without incurring AMT. If you do this year over year, for 10 straight years, you could exercise and hold nearly $350,000.

Ultimately, every tax situation is different and you should run a detailed tax calculation on your own (or with the help of an advisor). But the opportunity is one that should be explored if you hold incentive stock.

Summing It All Up

The year-end exercise up to the AMT crossover point is nothing new. What is new is the changing tax laws that may create additional room to exercise and hold more incentive stock options each year. As the opportunity to exercise and hold gets bigger, so does the opportunity to take advantage of this with good planning.

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.

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.

 

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