The alternative minimum tax will likely impact your tax liability if you’ve exercised and held incentive stock options
Incentive stock options (ISOs) gives some employees an opportunity to buy stock at a discounted price. Since you don’t have to report regular taxable income at the time of grant or exercises (only upon selling the stock), many people view ISOs more favorably than other types of equity compensation. However, there’s a catch.
When you exercise and hold an ISO, be keenly aware of the bargain element. The bargain element is the difference between the strike or grant price and the fair market value at the time of exercise. That amount (multiplied by the number of shares) must be reported as taxable income for alternative minimum tax (AMT) purposes if you do not sell the stock in the same calendar year of exercise.
Here’s a closer look at the AMT and how it affects your employee stock options.
What is the Alternative Minimum Tax and How Does it Work?
The AMT is a separate, parallel tax system, designed to ensure that certain taxpayers pay their fair share of taxes. After calculating both your regular tax and your AMT tax, you pay the higher of the two amounts.
The Tax Cuts and Jobs Act of 2017 (TCJA) modified the exemption thresholds to substantially higher amounts. The law also eliminated the deduction for miscellaneous itemized deductions and capped the state and local tax deduction to $10,000, both of which are non-deductible for AMT. As a result, significantly fewer households are subject to AMT than were during the 2017 tax year.
There are two rates for the AMT: 26 percent and 28 percent. Taxpayers who are under the AMT threshold will pay 26 percent, while those subject to AMT over the threshold will pay the 28 percent marginal rate. The threshold is $197,900 for single filers and married couples filing jointly, or $98,950 for married couples filing separately.
AMT exemptions are higher than the standard exemption. But once your income hits a certain level, the exemption starts to phase out. Twenty-five cents for every dollar of income over the phase-out level will disappear from the exemption. Here’s the breakdown:
|2020 Exemption||2020 Phase Out Level|
|Single filer/Head of household||$72,900||$518,400|
|Married filing separately||$56,700||$518,400|
|Married filing jointly||$113,400||$1,036,800|
Inflation-adjusted on an annual basis
You can calculate your AMT taxable income using Form 6251. You will only owe AMT if your AMT tax is higher than your normal tax calculated on your 1040.
AMT’s Impact on Employee Stock Options
When you receive incentive stock options, you do not have to claim them as income on the grant date or the vesting date. When you exercise your stock options, you can do one of the following:
- Purchase and hold the shares indefinitely
- Purchase and sell the shares in that same calendar year
- Purchase and sell the shares within 12 months but in a different calendar year
- Purchase and sell the shares at least one year after exercise but less than two years after the grant date
- Purchase and sell the shares at least one year after exercise and at least two years after the grant date
For tax purposes, the first and fifth options are viewed as the most favorable. Waiting at least two years after the original grant and at least one year after exercise to sell the stock will qualify as a long-term capital gain (taxed below your normal income tax rate).
Options 2, 3, and 4 are what is known as disqualifying dispositions of your options. This means that your bargain element is no longer applied towards AMT as a preference item. However, the difference between the strike price and the price at which you sold the option is added to your ordinary income for the year in which you sold the stock.
However, each of the above options will have different AMT implications.
Let’s say you were granted 100 shares of ISOs at $25 per share, with a market value of $50 at the time of exercise. If you decided to hold onto the shares, you would need to report a bargain element of $2,500 as an AMT preference item ([$50 market price – $25 exercise price] x 100 shares = $2,500).
While a transaction of this magnitude is unlikely to trigger AMT for individuals or partners with a significant ordinary income, it is important to calculate how much AMT “budget” you have in any given calendar year to avoid the AMT trap (the amount of options you can exercise without incurring AMT).
If you exercised and sold the stocks in the same calendar year, an AMT preference item wouldn’t apply because the gains would be taxed at your ordinary income tax rate via a disqualifying disposition. If you hold the shares for at least 1 year past the exercise date and 2 years past the grant date, the bargain element will be subject to your applicable state and federal long-term capital gains rate.
Calculating AMT adjustments can be a complicated process, and paying AMT isn’t always a bad thing. Work with a tax professional who can help you build an integrated tax plan that accounts for future expected earnings as well as the more complex filings that can come along with it.
How to Avoid Costly AMT Pitfalls When Exercising Stock Options
One way to minimize AMT impact is to exercise the shares you plan to hold early in the year. This gives you 12 months to complete a disqualifying disposition in the event the stock price declines substantially in the year. As you approach the end of the year and have a good sense at what your tax filing will look like, you can nail down if in fact you are subject to AMT, and take corrective action by completing a disqualifying disposition.
Another option is to see if your company allows early exercising. This lets you exercise your shares immediately upon grant and file an 83(b) election that would allow you to pay taxes on your shares on the day of exercise. Because you’re paying taxes on the grant price, there is no spread that will qualify for AMT. The downside is that you’d be paying income tax on the value of stocks that you may not ultimately receive or that may be worth less in the future.
The best option is to consult with a financial advisor on AMT implications, preferably before you exercise your options. Doing so will help you maximize your gains and minimize your tax obligations.
Steven Hanks, CFP® serves as an advisor in Brighton Jones’ Portland office.
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