How Incentive Stock Options and the Alternative Minimum Tax Work

by | Oct 12, 2018 | AMT, Stock Options, Tax Planning

How Incentive Stock Options and the Alternative Minimum Tax Work

by | Oct 12, 2018 | AMT, Stock Options, Tax Planning

 

Incentive Stock Options, or ISOs, are a form of equity compensation. They feature an exercise price and a vesting schedule and as they vest, you can choose whether or not you’d like to exercise those options

You don’t pay ordinary income tax when you exercise your options. But you could have to pay the alternative minimum tax.

 

The Alternative Minimum Tax on ISOs

A simple math formula determines how much income from the exercise of your ISOs might be subject to alternative minimum tax, or AMT. Here’s how you can calculate your potential AMT exposure when you exercise your options:

Number of ISO Exercised x (Current FMV – Exercise Price) = The Bargain Element

Here’s an example of how this formula works with actual numbers. If you had 20,000 vested incentive stock options with an exercise price of $10.00 and a current FMV of $40.00, the bargain element would be $600,000 — and that could be subject to alternative minimum tax.

20,000 x ($40.00 – $10.00) = $600,000

Note I said it could be subject to AMT. The question now becomes, “will all of my ISO bargain element be taxed under the AMT?”

The answer? Maybe. Maybe not.

Failing to fully understand the AMT and how it works is a common mistake we see when a tech employee begins working with us. They might also fail to calculate their bargain element correctly, which means their estimate for alternative minimum tax is all wrong.

 

What You’ll Actually Owe on Your ISO Bargain Element Is Not So Simple

Let’s continue our example above and say your ISO bargain element is $600,000. What we see some people do is take that $600,000 and multiply it by the rate for alternative minimum tax, which is 28%.

They then say, “well, I know my AMT! I owe $168,000 because $600,000 x 0.28 = $168,000.”

No, no, no. Not so fast — because taxes are not that simple!

All you really know at this point in the example is that you recognize $600,000 as income for the alternative minimum tax. What you don’t know yet is how much of that will actually be taxed.

 

How the AMT Tax Calculation Works

The good news? You can figure it out. You just need to follow this process:

  1. Start by calculating your total bargain element. Remember, that’s: Number of ISO Exercised x (Current FMV – Exercise Price).
  2. You’ll report this number on IRS form 6251, line 14.
  3. The formula that determines whether or not you pay the AMT on that number is as follows:

(Taxable Income, which you can pull from line 43 of Form 1040 + Other AMT Items, which is usually $10,000 of state income tax or property tax + Bargain Element from ISOs) – Your AMT Exemption.

The AMT exemption is $70,300 if you’re single. It’s $109,400 if you’re married filing jointly.

The resulting number of this formula is your Alternative Minimum Taxable Income, or AMTI:

  • 26% on the first $191,500 of AMTI
  • 28% over $191,500 of AMTI

Finally, you then subtract that number from your regular tax (line 44 of Form 1040) to arrive at your actual AMT owed.

Easy, right?

Well, actually, it gets even more complex than this thanks to the AMT Exemption Phase Out. This causes you to start losing your AMT exemption at $500,000 of AMTI if you’re single and $1,000,000 if you’re married.

This introduces more complication into the process of knowing how much AMT you actually owe — and how to properly plan for that tax bill when it comes. That’s why we highly recommend you hire a professional to work with you through this process, because the AMT is nothing to play with.

Not worried because you can’t sell your shares? You should be. You will still owe AMT even if you cannot sell your shares after you exercise ISO! So hire a pro and prepare now for the inevitable tax hit.

 

ISO and AMT Case Study: A Real Life Client Example

We’ll share some real numbers from a client case we saw recently. This client sold shares in a tender offer, then used the resulting cash to exercise more ISO.

Here are the numbers they worked with, as plugged into the calculation to determine how much AMT they’d owe:

  • Taxable Income under the regular rules: $195,376 (plus $10,000 in state income taxes)
  • Plus $134,781 from ISOs
  • Minus $109,400 AMT exemption

Based on these numbers, the AMT taxable excess was $230,757. The first $191,500 was taxed at 26%, which equaled $49,750. The next $39,257 of the taxable excess was taxed at 28% to equal $10,992.

That brought the total tentative minimum tax to about $60,742. Next, we subtracted the regular tax of $35,477 to arrive at the additional AMT owed of $25,265.

The client owed $25,265 for AMT because of  ISO were exercised — but they (and you!) would never know it if they simply multiplied $134,781 by AMT rates of 26% or 28%.

Again, taxes are never that simple — which is why it can literally pay in saved tax dollars and other financial mistakes to hire a professional who understands this kind of compensation to work with you.

 

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