AMT and ISOs Clarified
In this article, I’m sharing what you need to know about the Alternative Minimum Tax (AMT) and Incentive Stock Options (ISOs). It includes:
1.) ISO Specifics
2.) AMT Explained
3.) Strategies to Lower AMT on ISOs
WARNING! This piece is appropriate for those with ISOs or those with sleeplessness.
ISO Overview
ISOs are a type of equity compensation that allow you to buy company stock at a fixed price, and they also have AMT implications. However, they have tax advantages that other types of compensation do not have.
For example, when you exercise an ISO, there is no applicable income tax. If you hold the ISO shares at least one year after exercise and two years after the grant date, the profit (the difference between the price when you received the ISO and what you sell the stock for) has a long-term capital gains tax. The long-term capital gains tax rate ranges from 15 to 20 percent.
What Kind of Options Do I Have?
Only employees get ISOs whereas non-qualified stock options (NSOs) can be granted to employees, board members, and consultants. If you don’t know what kind of options you have, it is explained in your option agreement. In case you can’t figure it out, consult your human resources department.
If you want to learn more, here is an article about ISOs and NSOs.
Important Terms to Remember
Strike price
This is the price you’ll pay for your ISOs, and the price is determined on the grant date of the option.
Bargain element
The difference between the market price on exercise date and the strike price is known as the bargain element.
AMT Basics
The Alternative Minimum Tax is a separate tax system that makes some taxpayers calculate their tax liability twice. First, it’s calculated under regular federal income tax rules, then under the AMT tax rules. The taxpayer pays the higher amount under the two calculations.
ISOs are subject to the Alternative Minimum Tax. As a result, your taxes can be more complicated when you have equity compensation like ISOs.
If you have ISOs, it’s very important to determine if you owe AMT, how much you may owe, and how you will pay the tax bill.
AMT Explained
Think of a pretty landscape with a vast, beautiful flowing river with a large rock in the middle of the river. The rock stays in the same place, but the river level ebbs and flows over the years. In this situation, the rock is the AMT (28% flat tax rate) and it stays the same. The water level in the river is the regular federal tax rate and it can fluctuate.
If the water rises and covers the rock, you don’t owe any AMT. For example, if your Federal tax rate is 37%, it’s higher than the AMT rate of 28%. However, if the water level dips below the rock, then you have to pay the AMT. For instance, you could be in the 24% Federal tax bracket, which is lower than the 28% AMT flat tax, so there could be AMT payable.
Ultimately, if the river covers the rock, you do not owe AMT, but if the water is too low and the rock is exposed, then you could owe AMT.
AMT Calculation for ISOs
The Alternative Minimum Tax includes the bargain element on ISOs. The bargain element is excluded from regular federal income taxes, and that is one of its advantages, but it is included in your AMT income when you exercise ISOs and hold them past the calendar year end.
If you exercise and sell ISOs in the same calendar year, there is an ordinary income tax and short term capital gains taxes. There is no adjustment for AMT.
However, if you exercise and hold ISOs past the calendar year end, there is an AMT adjustment for the bargain element.
For example, let’s say you have 10,000 ISOs with a strike price of $10, and when you exercise the ISOs, the stock price is $50. The difference between the stock price and strike price is $40, multiplied by the number of ISOs exercised (10,000) is the bargain element ($400,000). Assuming a flat 28% AMT tax rate on $400,000 bargain element, the total AMT due would be $112,000.
Methods to Lower AMT Impact on ISOs
There are many ways to handle AMT when you decide to exercise your ISOs. The strategies have advantages and disadvantages, and there is not one strategy that will work for everyone because of factors related to your income, tax situation, and risk tolerance. Here are some ideas for managing the AMT.
Early Exercising
If your company allows early exercising, within 30 days of the ISO grant, exercise the option and file an 83(b) election. You pay ordinary income taxes on the shares on the day of exercise.
With an 83(b) election, you prepay your tax liability on the grant price and skip the AMT. However there is risk with this strategy. You will pay income tax on the value of the stock when granted but the stock may decline in value or be worthless by the time you sell.
Exercise Early in the Calendar Year
The calculation to determine Alternative Minimum Tax is based on calendar year. Exercise your option early in the year, and as the year winds down, you will have a better understanding of what your tax bill will look like. If you will be subject to AMT you can sell the shares in the same calendar year to avoid it. There is always a risk, and with this technique, selling the shares in the same calendar year is a disqualifying disposition. You would have to pay ordinary income tax on any gains, rather than the lower long-term capital gains rate.
Crossover Point
If there is no ISO activity in a calendar year, the regular federal tax is higher and no Alternative Minimum Tax is due. Assuming you have ISOs from a previous year, there is an opportunity to exercise some ISOs up to the threshold where AMT meets the regular federal tax. With this planning, you will not have to pay the AMT.
Comprehensive Strategy
AMT is complex and a big concern for those with ISOs. When exercising ISOs, it’s critical that you understand the implications of the AMT tax and the regular federal tax systems, along with the risks of continuing to own shares in your employer.
ISOs can cause capital gains taxes and impact other investment decisions, so it’s important to understand the comprehensive financial plan while developing an ISO strategy.
Your financial situation is unique to you, so it’s best to speak with a financial planner and a tax professional before making decisions on your ISOs.