The Alternative Minimum Tax and Its Impact on ISOs

If you haven’t read our article on ISOs and the basics of how they work, I would encourage you to check that article out before reading further. If you have checked it out or are familiar with ISOs, an element of ISOs that often gets overlooked is how the Alternative Minimum Tax(AMT) affects ISOs. In this article, we will cover AMT at a high level and how they can impact your tax situation if you have ISOs.

What are Incentive Stock Options (ISOs)?

What is Alternative Minimum Tax?

The Alternative Minimum Tax is an entirely separate tax system designed to ensure high-income earners pay their fair share. Under the Regular income tax system that you are likely familiar with, you can have certain tax deductions and credits to reduce your overall income. From there, there are various tax rates(brackets) that you would look at to determine your tax liability for the year. The AMT system is similar, however certain deductions, credits, and preference items are added back in. In any given year, your tax liability is determined by which system’s tax is higher. In most cases, the regular tax system is the higher number and that is the number you pay every year. 

*Whatever system’s tax bill is higher, is the one you pay

AMT and ISOs:

If you recall, one of the neat tax features of ISOs is that you can exercise your stock option and hold on to the stock to potentially avoid additional ordinary income and defer capital gains.  However, let’s assume this:

• Your company stock is valued at $50 a share
• You have vested ISOs and can buy 1000 shares at $10 a share
• The difference between $50 and $10 is called the Bargain Element, a preference item for AMT calculations

If you exercise an ISO and you choose not to sell it in that calendar year, then the bargain element is added to your AMT calculation as a preference item.  In this case, it is $40,000 (Fair Market Value – Strike Price * Number of Shares). 

RELATED READING:

83(b) Election and Restricted Stock Compensation

What Happens if You Owe AMT?

If you end up having a tax liability that you need to pay associated with AMT you will need to keep track of it. The reason for this is that excess tax paid for AMT can be used a tax credit in future years.

In this case, the bargain element caused the AMT system to generate a higher tax liability. You will now pay an extra $5000 in tax due to the AMT being higher than the Regular System. That extra $5000 can be used as a credit towards the regular tax system in future tax years. It is absolutely necessary that your team of financial professionals you work with help you keep track of this so that your credit does not go to waste.

Additionally, working closely with a good financial planner and/or CPA can help you come up with a plan on how much of your ISOs you should exercise and when in order to help reduce tax liability associated with AMT. If you feel like you could benefit from this type of planning or have additional questions, feel free to contact us or set up a call to learn more about comprehensive planning with MDRN Wealth.