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When you are exercising Incentive Stock Options (ISOs) – it is essential to understand the implications of the Alternative Minimum Tax (AMT).

One of the most complex and least understood areas of the tax code, the Alternative Minimum Tax (AMT) was enacted in 1969 to prevent higher-income earners from paying too little tax because they were able to take a variety of deductions or exclusions.

A key factor for those deciding whether and when to exercise their ISOs is the impact, and mitigation, of the AMT. A lack of knowledge of how AMT works and how it can be managed can adversely impact your decision whether to Exercise and Hold or Sell (Same Day Sale) your ISO positions.

This Guide takes you through some of the key AMT considerations when assessing the Hold vs. Sell outcomes.

1. What is the Alternative Minimum Tax?

AMT is a tax calculation that runs “in the background” to the regular tax calculation. All tax software runs AMT calculations on every return – however, you usually only see the AMT calculation when it results in an AMT liability that is in addition to the Regular tax liability.

As taxpayers must pay the higher of the calculated “AMT liability” and the “Regular liability,” this can often be an unpleasant surprise.

AMT includes more income items and allows fewer deductions than the regular tax calculation.

With particular reference to ISOs, the difference between the Strike Price and the Fair Market Value (FMV) on an ISO exercise will give rise to AMT income (and can result in an AMT liability) in the year of exercise. This FMV-Strike price is referred to as the ISO “Spread” and is not a taxable item for the Regular tax calculation.

  • The AMT top rate of 28% is lower than the regular tax top rate of 37%
  • For Californians, the state AMT rate is 7% compared to the regular top tax rate of 13.3%
  • For New Yorkers, the state AMT rate is 6%
2. The Minimum Tax Credit

Where AMT tax is paid in one year, the amount of AMT paid is available to carry forward to offset against a future year’s Regular tax liability. An AMT Credit CANNOT be used to offset future years’ AMT liability! This AMT credit carryforward is referred to as the Minimum Tax Credit (MTC) and is computed on Form 8801.

The MTC may be used to reduce Regular tax liabilities in future years but ONLY when the Regular tax liability is higher than the calculated AMT liability. If the calculated AMT liability is higher than the Regular tax liability in the future year, the Minimum Tax Credit CANNOT be utilized in that year and must be carried forward to a tax year where the Regular liability exceeds the calculated AMT liability.

3. What Triggers the AMT Tax? The three main triggers of AMT are:
  1. Having high household income with a significant number of deductions
  2. Realizing a large capital gain
  3. Or most commonly, exercising Incentive Stock Options

Looking solely at the stock option trigger, exercising ISOs and holding them into the next tax year can create AMT income. The “in the background” AMT calculation then determines if there is any AMT tax due. In the AMT calculation, the Standard or Itemized Deduction available for Regular Tax purposes is replaced with a much larger AMT “Exemption Amount.” This is favorable for taxpayers. The 2023 AMT Exemption Amounts are as follows:

AMT Exemption & Phase-Out Thresholds
AMT Exemption & Phase-Out Thresholds

Note that if AMT Income (including that generated by the ISO exercises) exceeds certain levels known as the “Phase-Out Thresholds,” then the AMT Exemption Amount starts to be reduced by $1 for every $4 that Income exceeds the Phase-Out Threshold. The Phase-Out Threshold is $578,150 (Single) and $1,156,300 (MFJ).

The downside to the AMT Calculation is that AMT tax is, in large measure, applied at a Flat-Rate of 28% - the traditional marginal tax brackets available for the Regular Tax calculation are not available for the AMT calculation. Whether this downside will result in additional AMT tax to pay very much depends on the level of the AMT Income and the level and character of other taxable income in the year in question.

For these reasons, the only true way to calculate whether the AMT tax will apply in any particular year is to run a simulated tax return in advance for the year in question. Most CPA firms do not run these simulations and hence nasty surprises occur at tax time. At BakerAvenue we run these simulations in advance as a matter course to anticipate these liabilities and adopt the appropriate mitigation and management strategies.

    4. Taxation for ISOs Regular Tax vs. AMT Tax

    The key to managing AMT and ISOs is to appreciate that the tax treatment between Regular tax and AMT tax, while radically different at the time of exercising the ISOs, is essentially a timing difference that is reversed when the ISO stock is subsequently sold.

    At exercise of the ISO, the AMT income (and tax liability) will – all other things being equal – be greater than the Regular taxable income (and liability). When the stock is subsequently sold and the preferential Long-Term Capital Gains (LTCG) rate applied to the disposal, the Regular taxable income (and liability) will (all other things being equal) be greater than the AMT income and liability – allowing the previously paid AMT tax to offset the Regular tax liability by virtue of the Minimum Tax Credit (MTC).

    Timing is Crucial

    Because the AMT “Tax Basis” in the ISO stock was adjusted upwards to FMV at the date of Exercise, while the Regular “Tax Basis” in the ISO Stock remained at the Strike Price – a subsequent sale of the ISO Stock will essentially reverse the position at the time of Exercise and, critically, allow the previously paid AMT tax to offset the Regular tax liability by way of the Minimum Tax Credit.

    The end result – if managed carefully – is that the ISO holder is able to:

    1. Exercise the ISO options,
    2. Benefit from appreciation in the company stock price
    3. Get the lower Long-Term Capital Gains tax rate of 20% on that appreciation

    The AMT tax won’t be an additional tax paid (if managed correctly) but is rather a temporary tax that can ultimately be recouped. The alternative to exercising your ISOs is an exit from the holding in the company at the highest marginal income tax rate.

    2021 brings opportunities and transitions to discuss a wide range of tax strategies for AMT, ISOs, retirement accounts, estate and gift taxes, and more.

    Click to download The Complete Guide to Tax Strategies for ISOs and AMT Optimization or contact us if you’d like guidance to navigate through the complexities of tax planning.

    The legal and/or tax information contained herein is general in nature, is provided for informational purposes only, and should not be construed as legal or tax advice. It does not involve the rendering of personalized investment advice and should not be construed as an offer to buy or sell, or a solicitation of any offer to buy or sell securities. All information is subject to change. This material contains references to concepts that have legal, accounting, and tax implications, and is not intended as legal, accounting or tax advice as Baker Avenue Asset Management LP is not engaged in the practice of law, tax or accounting. Accordingly, any information in this document cannot be used by any taxpayer for purposes of avoiding penalties under the Internal Revenue Code. Information presented is believed to be factual and up-to-date, and BakerAvenue cannot guarantee that such information is accurate, complete, or timely. Laws of a particular state or laws which may be applicable to a particular situation may have an impact on the applicability, accuracy, or completeness of such information. Federal and state laws and regulations are complex and are subject to change. Changes in such laws and regulations may have a material impact on pre-and/or after-tax investment results. BakerAvenue makes no warranties with regard to such information or results obtained by its use and disclaims any liability arising out of your use of, or any tax position taken in reliance on, such information. Consult your own attorney and/or accountant for advice regarding your particular situation

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