Exercising Incentive Stock Options? What You Need to Know About the Alternative Minimum Tax
Congrats on your ISOs, and welcome to the “Needs to calculate AMT” club.
Incentive stock options (ISOs) can feel rewarding, exciting, and also a bit daunting. Stocks with favorable tax rules, like ISOs, come with a set of tax laws you’ll want to familiarize yourself with so you can make the best financial decision for you. In this article, we’ll start with a primer on ISOs and then discuss in more detail how the alternative minimum tax (AMT) might impact your selling strategy.
Incentive Stock Options at a Glance
- Incentive stock options (ISOs) are a type of tax-advantaged stock granted to employees to buy shares, typically at a price lower than the fair market value.
- ISOs can be taxed as long-term gains instead of regular taxable income. If you hold ISOs until at least one year after exercise and two years after the grant date, they aren’t taxed as regular income. Rather, they count as long-term capital gains, and the savings are significant: as much as 20 percent depending on your income bracket.
- That said, you may need to pay an alternative minimum tax. The catch with ISOs is you’ll need to file an AMT adjustment on the “bargain element,” the difference between the price you pay for the shares and their fair market value. This may trigger you to pay more in taxes than you would otherwise. When you’re determining how and when to exercise and sell your ISOs, you’ll want to take into account the AMT adjustment.
- Both depend on when you sell your ISOs. By choosing when you sell your shares, you can avoid the AMT adjustment or opt for the long-term capital gains tax advantage.
|Purchase and…||ISO gains taxed as…||Requires adjustment to AMT?|
|Sell in the same calendar year||Regular taxable income; file as a short-term sale||No|
|Sell within 12 months, but over two calendar years||Regular taxable income; file as a short-term sale||Yes, the bargain element in the year of the purchase|
|Sell at least one year after exercise but less than two years after the grant date||Regular taxable income; file as a long-term sale||Yes, the bargain element in the year of the purchase|
|Sell the shares at least one year after exercise and two years after the grant date||Long-term capital gains||Yes, the bargain element in the year of the purchase|
|Hold indefinitely||Not taxed until you sell||Yes, the bargain element in the year of the purchase|
Note: Calculating AMT adjustments can be a complicated process, and paying AMT isn’t always a bad thing. We recommend working 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 those earnings.
How do I know what type of stock I have?
ISOs are only granted to employees, whereas non-qualified stock options (NSOs) can be extended to anyone, including employees, consultants, and directors.
If you don’t know which type you have, it should be listed clearly on your option agreement. If it’s not, reach out to your HR department liaison, and they should be able to help.
Want to learn even more? We have a whole article on the tax implications of ISOs vs NSOs.
Key ISO terms to remember
- Grant price: The price you’ll pay for your ISOs. This is often at a discount versus the fair market value.
- Bargain element: The difference between the grant price and the fair market value. If you exercise but do not sell your ISOs in the same calendar year, this amount is included when calculating your income for the AMT.
Tax Benefits of Incentive Stock Options
Taxes are one reason people like ISOs. With an ISO, you don’t have to pay taxes when you exercise your shares, only once you sell your shares. On top of that, if you wait at least one full year after your shares vest and two years after your grant date, the stock’s gains will qualify as capital gains rather than ordinary income, which is a potentially significant savings. Capital gains rates are income-dependent, but they’re all lower than the income tax rates in the corresponding bracket, some by as much as 20 percent.
|Long-Term Capital Gains Tax Rate||Income Tax Rate||Rate Difference|
|$492,301 and higher||20%||35–37%||15%–17%|
The 2023 capital gains tax rate is up to 20 percent lower than the corresponding income tax rate. That’s a major tax advantage for ISOs.
What is the Alternative Minimum Tax (AMT)?
When determining when to exercise and sell your ISOs, you’ll also want to be mindful of the AMT. Never heard of it? That makes sense; it may not have applied to your tax situation until now. We’ll walk you through the AMT and the implications it may have on your ISOs.
As you might guess from the name, the alternative minimum tax is a tax floor. Its predecessor was put in place in 1969 to make sure that high-income taxpayers paid at least a certain amount in taxes. Today, it’s a parallel tax equation: if your income is high enough, you’ll calculate your regular income tax and your AMT, then pay the higher of the two.
What’s the difference between ordinary income tax and the AMT? Your ordinary taxable income and your alternative minimum taxable income are calculated differently. The AMT doesn’t allow certain exemptions and exclusions, including state and local taxes, itemized medical expenses, and, most relevant to our discussion, the bargain element on your ISOs.
The bargain element, or the difference between what you paid for the stock (your grant price) and what it was worth that day (the fair market value) is excluded from your ordinary income tax as one of its tax advantages, but it is included in your AMT income when you exercise your ISOs and hold onto them that calendar year.
Do I have to pay AMT?
In 2020, if you make more than $72,900 as a single filer ($56,700 as a married person filing separately, or $113,400 for married people filing jointly), you’ll need to calculate your AMT and determine if it’s higher than your regular taxable income. If it is, then yes: you’ll have to pay it.
The AMT has an “exemption,” which is like a standard deduction based on your filing status. Once your income hits the phase out level, the exemption will begin to… phase out. For every dollar above the phase out level, the exemption decreases by $0.25. At four times the phase out Level, the exemption is fully depleted.
Here’s the breakdown:
|2022 Exemption||2022 Phase Out Level|
|Single filer/Head of household||$75,900||$539,900|
|Married filing separately||$59,050||$539,900|
|Married filing jointly||$118,100||$1,079,800|
Note: Inflation-adjusted on an annual basis
A bit of good news: If you do have to pay the AMT, the difference between the AMT and your regular tax is noted as a minimum tax credit, and you can carry that credit forward into another year.
The AMT tax rate
There are two rates for the alternative minimum tax: 26 percent and 28 percent. Taxpayers who are under the AMT threshold (in 2022, the threshold is $206,100 for single filers and married couples filing jointly, or $103,050 for married couples filing separately) will pay 26 percent, while those subject to AMT over the threshold will pay the 28 percent marginal rate.
You can calculate your AMT taxable income using Form 6251, tax software, or with the help of a tax professional or financial advisor. You will only owe AMT if your AMT tax is higher than your normal tax calculated on your 1040.
How does AMT Impact ISOs?
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, you can do one of the following:
- 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
- Purchase and hold the shares indefinitely
First, let’s look at how the gains are taxed in these scenarios
For tax purposes, options 4 and 5 are viewed as the most favorable. The date you sell the stock will determine how the gains are taxed. 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, which is taxed below your normal income tax rate. Because of this, they’re called qualifying dispositions.
Options 1, 2, and 3 are disqualifying dispositions of your options. The difference between qualifying and disqualifying dispositions is pretty easy to understand and remember: both are the sale or transfer of stock, but qualifying dispositions qualify for preferential tax treatment and disqualifying dispositions don’t.
ISOs are qualifying dispositions as long as you sell one year after exercising and two years after the grant date. If you don’t meet both conditions, then it’s a disqualifying disposition and you’ll pay ordinary income tax on the gains.
Next, note if the AMT applies
In almost all of these scenarios, your bargain element will be applied towards AMT as a preference item. The exception is option 1: because you bought and sold the shares within the same calendar year, you won’t need to adjust your AMT income. Instead, the bargain element will be taxed as ordinary income.
Example: 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 buy and hold onto the shares for the duration of the calendar year, 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 couples with typical income, it is important to calculate how much AMT “budget” you have in any given calendar year before you exercise. That is, the number of options you can exercise without incurring AMT.
Remember: paying AMT isn’t always a bad thing.
4 Ways to Avoid Costly AMT Pitfalls When Exercising Stock Options
Exercise early. Check to see if your company allows early exercising (early as in within 30 days of the grant). If available, you have the option to exercise your shares within the first 30 days of the grant and file an 83(b) election that would allow you to pay ordinary income taxes on your shares on the day of exercise.
With an 83(b) election, you’d pre-pay your tax liability on the grant price and skip the AMT altogether. There is a risk here: you’ll be paying income tax on the value of stocks that you may not ultimately receive as they may decline in value, or may even be worthless by the time you sell.
Exercise in January. Another way to minimize AMT impact is to exercise your shares you plan to hold early in the year. As you approach the end of the year and have a good sense of what your tax filing will look like, you can nail down if you are subject to AMT and opt to sell in the same calendar year if you’d like to avoid it. The downside: you’d be taking a disqualifying distribution and so would pay ordinary income tax on any gains, rather than long-term capital gains tax.
Run a multi-year projection. We recommend taking a long view on this decision. It’s possible that you may trigger an AMT that’s higher than your normal tax in some years, and not others.
By calculating your AMT for the next few years, you can time your elections to optimize your tax rates, accelerating or delaying certain elections as needed. You can calculate your AMT using Form 6251, using a tax software, or with the help of a tax professional or financial advisor.
Consult with a financial advisor. The best time is to seek the advice of a professional before you take any action. (Remember, not exercising your options, or missing the early exercise window by waiting, is also an action.) Your situation is uniquely yours, so the only way to figure out the optimal option is to take a look at it closely.
This article was updated on October 30, 2023.
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