Guys, the Alternative Minimum Tax (AMT) & all. the. things. about it are confusing as heck. Like, that’s just how it is. I’m not even going to pretend with you right now. And unfortunately, it doesn’t look like the IRS is going to simplify the AMT credit carryforward with ISO anytime soon… so we’re doing our best to get as much helpful information into your hands as possible. Here’s what we’ve written about it in the past:
- How the AMT rules were changing under the new tax laws
- How AMT works with Incentive Stock Options (ISO) in a real-life client example
- How you’ve got to understand cost basis on your ISO shares, so you only pay what you owe to the IRS, and not more.
It’s a lot of good information, but we’re still getting loads of questions, and it’s understandable.
You guys are intelligent, so you’re gobbling up all that information, and you want to know more, things like:
- Exercising and holding ISO
- Triggering the AMT
- Generating an AMT credit carryforward with ISO (the minimum tax credit)
- Adjusting cost basis on the sell of shares from exercising and holding ISO
So today we’re going to dive into the topic of the Minimum Tax Credit (amt credit carryforward) and how it works with ISO.
So if you’ve got an IPO or acquisition happening this year, you exercised enough ISOs to trigger the AMT, or you have ISO shares that you’ve held onto over the years… this post is for you.
What is the AMT credit carryforward (Minimum Tax Credit)?
The Minimum Tax Credit exists to help keep people from paying tax on the same thing for multiple years. That’s a simplification of it, but if you want more of a deep dive, check out this article on The AMT Advisor.
Basically, if you’ve paid AMT in the past, you may qualify for an AMT credit that you carryforward and use in part each year. To figure out whether or not you qualify for it, you or your accountant have to fill out Form 8801 (Credit for Prior Year Minimum Tax) come tax time.
How Does the Alternative Minimum Tax Work (AMT)?
To better understand AMT credit carryforward, it helps to know that AMT is an alternate tax calculation that’s separate from your regular taxes.
The regular tax is what we all pay every year… and is exactly what most people think of when they file their taxes.
So if you do the AMT calculation and it’s the same or lower than your regular tax, you don’t “trigger” it, and therefore don’t have to pay anything extra.
But if the AMT calculation is higher than your regular tax calculation, then you trigger AMT and have to pay the difference.
Fortunately, the two different calculations treat different tax items differently, so you can make sure to avoid an overlap. (And, in this case, get Minimum Tax Credit to help offset any overlap that might be there.)
For example, some things that are deductible for regular income tax (like $10,000 of state income tax), aren’t deductible under AMT.
Likewise, things that aren’t taxable as income with regular tax calculations, like the exercise of ISOs, are taxable under the AMT.
AMT Credit + ISO: What Happens
Let’s say you decide to exercise a lot of your ISOs in one year. (Congratulations!)
The AMT calculation here is concerned with something called the bargain element, and it’s the difference between the price you pay to exercise, and the fair market value at the time you exercise. (Because remember, with ISOs, you’re usually paying less than the rest of the market.)
Here’s what that looks like:
Fair Market Value – Exercise Price = Bargain Element
So, if you exercise enough ISO in a single year, you gain enough of a bargain that eventually you cross the line where the additional AMT on your bargain element is higher than what you owe in normal taxes…. So you have to pay the AMT. Then, from that point forward, each additional ISO exercised will increase your AMT bill.
But if you don’t cross that line, you don’t have to pay the AMT, and only have to pay capital gains when you sell those shares, on the amount of your long-term capital gain. Here’s what that looks like:
Sale Price – Exercise Price = Capital Gain
So, basically, with the AMT you’re taxed at the “moment” you exercise (even though you may not actually pay until April)… but with regular tax, you’re only taxed when you sell.
The problem with this is, you may end up getting taxed twice on the same shares… which you do not want to do.
This is where the AMT credit carryforward comes in… to protect you from double taxation. (You just have to know that it’s there so you can take advantage of it… otherwise, the IRS will happily take money from you on the same thing twice.)
AMT credit carryforward + ISO
Normally, we’re only concerned about the AMT calculation if it’s higher than the regular tax calculation. (Because then that means you have to pay the difference.)
However, if you have a Minimum Tax Credit (MTC) from previous years, that can reverse it, because it lets you pay the lower AMT calculation.
Normally:
AMT calculation – regular tax calculation = AMT owed
But with Minimum Tax Credit:
Regular tax calculation – AMT calculation = amount of MTC you can use to reduce taxes. (Yes, this would be a negative number, and therefore your “credit.”)
So… when you exercise your ISOs to the point you find yourself paying AMT, you generate a Minimum Tax Credit you can use in future years. (Again, use IRS Form 8801 to report it.)
The really cool thing is, you can keep using the Minimum Tax Credit indefinitely until all your credit is used up. ????
What to Do in Future Years After Paying AMT on ISO
The good news is, you’ll probably be able to use at least part of your AMT credit carryforward from ISO every year until the credit runs out.
But since under the new laws most people who don’t exercise won’t have to pay the AMT, there will still probably be a way to use some of your MTC to reduce your taxes, even if you don’t owe AMT.
Most of the time, we see clients able to use anywhere from $5,000 to $10,000 of their Minimum Tax Credit when they don’t exercise additional ISO, and they don’t sell the shares from exercising the ISOs that triggered the AMT in the first place.
When to Use Your AMT Credit Carryforward + How Cost Basis Affects It All
You’ll utilize most of your MTC the year you decide to sell your shares.
But when you do pay the AMT, you now have two separate cost bases to consider.
Cost Basis #1 is your regular tax basis, which is the price you paid to exercise your Incentive Stock Options.
But Cost Basis #2 is the fair market value (or FMV) at the time you exercised. (The FMV is what was used to determine how much AMT you owed, remember? And this gets reported on Form 3921, if you ever need to look it up.)
Having two different cost bases can get a little confusing, but it’s not necessarily a bad thing.
Yes, the higher AMT cost basis creates a larger negative difference between your AMT calculation and your regular tax calculation… and that’s what makes you owe AMT in the first place.
BUT, it also means that after you pay it, you have more Minimum Tax Credit to claim the year you sell.
You got all that? Okay, let’s pause and take a breath for a moment.
Don’t worry if this stuff seems overly complicated… that’s because it is. Which is why it can be a good idea to work with someone who can read into all the subtleties of your individual situation, with your individual company.
Let’s Look at a Real Life Example
Let’s say Client A works at a private tech company, and is a single taxpayer. She doesn’t have children or own a house, and makes $250,000 per year.
Her company gave her ISO, with the exercise price of just $2 per share. Because it’s such a good deal and she believes in the company wholeheartedly, she decides to exercise her ISO as much as she possibly can, using a total cost strategy. (Meaning, she’s not just buying shares willy-nilly…. She’s taking into consideration how much it will cost her come tax time, too… and adding the cost of the shares she’ll buy to the cost of what she’ll pay in AMT to get the total cost.)
She also started doing this all the way back in 2020.
That year, she bought 40,000 shares at the $2 exercise price, and the FMV then was $8, so AMT was paid that year.
She skipped 2021, but in 2022 bought 30,000 shares, still at her $2 exercise price, but by then the FMV had risen to $9 per share, and again she had to pay AMT.
Then, in 2023, she bought another 30,000 shares at $2 each, when the FMV had gone up to $10. Again, she triggered the AMT.
So, by 2024, she had $125,000 in Minimum Tax Credit to carry forward and use when she sells those shares.
Then, the company is acquired by another company at $20 per share in an all-cash acquisition. This means all 100,000 of her shares will be sold at the $20 price tag, and her gross proceeds are $2 million. (She did pretty well for herself, didn’t she?)
When you subtract the $200,000 she spent to acquire those shares (regular tax cost basis) from the $2 million she made from the sale, you get $1.8 million of long-term capital gains to be taxed under the regular tax calculation.
So with the taxes on her set $250,000 per year salary, plus the $1.8 million she earned on her shares in the acquisition, you get a total tax bill of $481,342.
But, we still need to figure out her AMT cost basis to calculate her gains according to the Alternative Minimum Tax calculations, not just the regular tax calculation.
In 2020, she bought 40,000 shares at $8 FMV, equaling a $320,000 cost basis.
Her 2022 purchase of 30,000 shares at $9 FMV equals a $270,000 cost basis.
And her 2023 purchase of 30,000 shares at $10 FMV equals a $300,000 cost basis.
In total, that’s an $890,000 cost basis for AMT, which is $690,000 more than the $200,000 cost basis used to figure out the regular tax calculation.
According to this, then, her gains under the AMT are $1.31 million, which is a whole $490,000 less than the regular tax gains.
So…. when we adjust the AMT cost basis, we can eliminate that additional $23,611 she owes in AMT, bringing that tax bill down from $481,342 to $457,731.
Then, we can fold in the $125,000 Minimum Tax Credit she has and reduce the taxes by another $74,389, bringing her bill down to $383,342… and letting her keep $98,000 in her pocket, instead of paying it to the IRS.
THIS is the kind of thing that’s possible when you pay attention to your cost basis and make sure it’s correct, and you make sure to carry forward your MTC to use when you sell your shares. (Otherwise, you could end up paying an extra $98,000 to the IRS leaving everyone none the wiser.)
Conclusion: The AMT Credit Carryforward with ISO Makes Sure You Don’t Overpay to the IRS
So, yeah, that was a lot of information.
But you’re an absolute hero for sticking through to the end, and you’ll be in a much better position with your ISOs, stock sales, and taxes because of it.
(Plus, you won’t end up over-paying the IRS by nearly $100,000.)
Just please, please, please make sure you always keep track of your different cost bases, and that you’re aware of your MTC so you don’t pay more than you owe–you earned that money and deserve to use it for your benefit!
And if you want some help figuring out the best action plan–or how you can reduce your taxes if you’ve just had a big acquisition or IPO and think you might have some MTC available, get in touch for a free call.
