Quick Guide to Tax Strategies for ISOs and AMT Optimization

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 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 an AMT tax liability if [FMV - Strike Price] X Total Number of ISOs Exercised is greater than the current year AMT Exemption Amount. 

 The 2020 AMT Exemption Amounts are as follows:

What does this mean for Year 2021?

• If your “income” from your ISO exercise is less than $73,600 for individuals (or $114,600 for married filing jointly), you are unlikely to owe any AMT at all.
• However, if total taxable income (including that generated by the ISO exercise) exceeds certain levels known as the “Phase-Out Thresholds,” then the Exemption Amount starts to be reduced by $1 for every $4 that Income exceeds the Phase-Out Threshold. The Phase-Out Threshold is $523,600 (Single) and $1,047,200 (MFJ).

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).

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.