You’ve likely heard of the term AMT or alternative minimum tax if you hold incentive stock options (ISOs). Because incentive stock options come with favorable tax rules, they can become subject to the mysterious AMT in the year of exercise. This creates “phantom income” that factors into the calculation for the alternative minimum tax. Therefore, you may be subject to AMT in the year of exercise unless you exercise and sell the ISOs in the same calendar year. Nevertheless, you’ll want to familiarize yourself with how AMT can impact your financial planning decisions so you can create a proactive equity compensation strategy.
The mechanics of how incentive stock options can trigger AMT might be easier to understand in a real-life example. But first, a little about AMT…
Many people don’t realize is that AMT is calculated alongside regular federal income tax. As a result, it often goes unrecognized since the majority of taxpayers won’t trigger AMT. In short, this alternative tax system was designed to ensure certain taxpayers pay the minimum amount of income tax. In other words, it creates “fairness” since some taxpayers receive benefits that can reduce their regular tax bills.
When preparing taxes through software or a tax professional, both the regular and the tentative minimum tax for AMT are calculated simultaneously. The tentative minimum tax is the calculation that determines if you’ll owe AMT. If the regular tax is higher, you pay that. If the tentative minimum tax is higher, you’ll pay AMT. This will make more sense in the example we’ll cover below.
The alternative minimum tax is the excess of the tentative minimum tax over the regular tax. When the tentative tax for AMT is calculated, certain income tax deductions (standard or itemized deductions), real estate taxes, and exemptions are removed.
Incentive stock options are an AMT preference item. The spread is factored as income for the tentative tax in the year ISOs are exercised. The spread is the fair market value at exercise minus the exercise price multiplied by the number of shares. This is also known as the bargain element, which is not taxable under the regular income tax calculation.
On the bright side, AMT only has two tax rates — 26% and 28%. For 2021, the 26% rate applies to $199,900, and any amount greater than $199,900 is taxed at 28%. In addition, some exemptions and phaseouts also factor into the AMT calculation, as you can see in the graphic below.
Now we can look at a real-life situation to make sense of exercising ISOs and AMT.
We will start by calculating the regular income tax for a professional (filed single in 2020) with a gross income of $95,377. After subtracting the standard deduction of $12,400 (2020), the taxable income is $82,977. This income runs through the regular federal income tax brackets to determine the total tax. In this case, the tax is $14,045.
The regular tax calculation above doesn’t show us something significant—the exercise of incentive stock options with a bargain element of $133,807. Remember, the bargain element is the difference between the exercise price and fair market value at exercise multiplied by the number of shares. In addition, the stock from the exercise was held past the 2020 calendar year, which makes AMT a possibility with a large bargain element.
Now we look at the tentative tax calculation to determine if there will be AMT (below). This calculation starts with the same taxable income number of $82,977. Then, however, the standard deduction and ISO bargain element are added. This gives us $229,184.
But remember, there is an AMT exemption of $72,900 (2020) for single taxpayers. This creates alternative minimum taxable income (AMTI) of $156,284 and lands in the 26% bracket for AMT, for a tentative minimum tax of $40,633 ($156,284 x 26%).
Still with me? Almost done! Since the tentative tax ($40,633) is greater than the regular tax ($14,045), this person is subject to AMT. But how much AMT?
The AMT amount is determined by subtracting the regular tax ($14,045) from the tentative tax ($40,633), which creates an alternative minimum tax of $26,588. This is essentially added to the regular tax to total $40,633.
Taxes withheld or paid for the tax year are applied toward the total tax. In this case, $14,356 was withheld from paychecks in 2020. As you can see, this tax withholding would have covered the regular tax bill of $14,045, but by exercising and holding ISOs, an additional $26,277 is due because of AMT!
While it’s possible to encounter an unexpected tax bill with AMT, there is some good news. AMT can become a tax credit for future tax years not subject to AMT. This essentially becomes an asset to carry forward. The AMT credit does not expire.
As you can see, AMT adds more complexities to an already confusing tax system. However, don’t be afraid of AMT when dealing with incentive stock options. Education and proactive planning are key with equity compensation. You can maximize your money and optimize taxes by implementing an option exercise strategy ahead of time. This can help reduce or limit the alternative minimum tax.
When needed, get help from a financial professional to guide you through an equity compensation strategy that considers your complete financial picture. If you are unsure where to begin and need guidance, we are here to help!
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