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|
|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
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.