Taxes can be complicated with equity compensation, especially with the Alternate Minimum Tax (AMT). The AMT can make exercising and selling Incentive Stock Options (ISOs) a very delicate decision.
Does it Apply to You?
There are several reasons for the AMT, and for our purposes we will be focusing on equity compensation and the AMT, specifically Incentive Stock Options. The other AMT items are beyond the purposes of this article.
Believe it or not there are 2 different tax systems – the regular tax code and the AMT.
It’s best to think about the tax systems like rocks in a river. The water is the regular tax code and the AMT is the rock. As long as the water covers the rock then the tax paid under the regular tax code is sufficient. However, if the water is low and the rock sticks out, then you pay the AMT.
ISO Timing and the AMT
When you exercise and sell ISOs in the same calendar year there’s no AMT adjustment. Gains are taxed as ordinary income and a short-term capital gain.
However, if you exercise and hold ISOs past year-end, you pay the AMT on the bargain element (the difference between exercise price of the ISO and fair market value of the stock).
Best Practice for Managing ISOs
So when is it best to exercise ISOs? Believe it or not there is an ISO best practice. It’s simple.
Exercise your options in the first quarter of the year and plan to hold shares. Taxes are due the following April so you can sell just in time to pay AMT, while meeting the one year holding requirement.
If share price drops during the course of the year, you can sell by December 31st to avoid the AMT.
With this strategy you have the maximum amount of time to sell the shares and cancel the AMT, especially if the stock takes a dive.
One more note, it’s very dangerous to exercise options late in the year!
AMT and Overall Strategy
The AMT with ISOs is a complicated matter. Every situation with equity compensation and the AMT is different, so it’s best to speak with your trusted advisors – both a CPA and a financial advisor to help you with these decisions.