Summer is just around the corner, and I met up with my good friend Lucas. He is getting ready for summer on Long Island! He is a very inquisitive fellow, and he was asking me about the Alternative Minimum Tax (AMT) credit. What is it exactly? How can you use it? Is it good, bad, or indifferent?
AMT Credit
Well, there are many things to understand about the AMT credit. First, there are two tax systems – the regular tax code and the AMT.
Think about floating down a river. There is water (the regular tax code) and there are rocks (the AMT). As long as the water is high enough and it covers the rocks, then the regular tax amount you pay is ample. However, if the water is low and the rocks are exposed, then you have to pay the AMT
The AMT makes you prepay taxes on income you haven’t realized. This can happen for a variety of reasons, but for our discussion, the AMT relates to Incentive Stock Options (ISOs).
ISOs
When you use an ISO there is a “spread.” It is the difference between the exercise price and the fair market value (FMV) of the stock at the exercise date. When you exercise the option and don’t sell the stock, typically you pay AMT on the spread.
Using the AMT Credit
To use the AMT credit, your regular tax liability must exceed the AMT in the future. This typically happens when you sell your stock (from the ISOs) and realize capital gains. You can apply your AMT credit carryforward to offset the difference and reduce your overall tax bill.
It helps to strategically time your credit usage in order to reduce your tax liability.
How Long Does it Last
AMT credits last forever going forward. However, they cannot be carried backward to offset prior year taxes. AMT credit accumulation can be frustrating. If you are stuck in the AMT system year after year, you may never be able to use the AMT credit. Additionally, state and local tax deductions lower your regular tax liability making it even harder for you to offset AMT in future years.
What to Do
You can time your stock sales in a way to utilize your AMT credits. Selling appreciated stock in a year when regular tax exceeds AMT allows for use of the AMT credit. Spreading ISO exercises over multiple years will help you balance AMT and prevent extreme AMT carryforward accumulation.
Remember to work with a CERTIFIED FINANCIAL PLANNER® and a qualified CPA when it comes to dealing with a tricky little beast like the AMT.