If you have Incentive Stock Options (ISOs), you may have heard a lot about the Alternative Minimum Tax or AMT. We’ll explain the basics of how the tax is calculated and how you can minimize or avoid the tax altogether.
What Is the AMT?
AMT was designed to prevent a perceived abuse of the regular tax laws through various tax breaks. A parallel computation of tax liability is done for both regular and AMT purposes using different rules for each computation.
The AMT computation is performed on Form 6251. The computation starts with the same taxable income from the regular tax computation. There are several additions added to the AMT base that can increase your tax bill. For example, net operating losses, depreciation differences, state income taxes and exercise of ISOs can all trigger AMT.
Depending on your income level in 2022 (under $539,900 single and $1,079,800 married), you are eligible for an AMT exemption ($75,900 single and $118,100 married). These amounts were expanded under the TCJA but are set to expire if not adjusted before the end of 2025.
Once these additions are added to the AMT taxable income, a flat tax rate of 26% or 28% is applied (depending on your income level). Your AMT is compared to your regular tax liability and you pay the higher of the two on your return.
Why Do ISOs Generate AMT?
As mentioned above, ISOs can trigger AMT. This is because any excess between the fair market value of the option over the exercise price is considered an AMT preference item (i.e. adjustment to income). If you recently received a grant of ISOs, the fair market value may be very close to the exercise price. So you may generate very little AMT or avoid it all together if you can exercise before the price jumps.
Let’s look at a quick example to see how this works.
Taxpayer is married and earns $250,000 in wages during 2022. In addition to wages, the taxpayer is trying to determine the impact of exercising and holding 1,000 shares of ISOs with a strike price of $10 and a fair market value of $95.
From the chart below, we can see that there is an AMT increase of $15,155 resulting from the exercise of the shares. This is because the AMT tax is greater than the regular tax by this amount.
This additional tax is the result of $85,000 more “income” for AMT purposes. Even though you may not be able to sell the shares yet, the Treasury rules treat you as receiving something of value.
Here is the detailed AMT computation (for the tax nerds out there). It shows the AMT exemption and the comparison of the regular tax and AMT.
So, How Can We Avoid AMT?
The best way to avoid AMT was mentioned briefly above. There is an AMT exemption that applies (provided you are under the requisite income level). This allows most taxpayers to exercise a certain amount of ISOs each year without being subject to additional AMT.
This amount varies each year depending on your income levels as well as the inflation adjusted exemption amounts. We regularly assist tax clients with this computation by performing a tax projection before the exercise of ISOs. If the fair market value is low enough, we are often able to make a significant dent in vested shares by careful management of the AMT exemption amount.
If the fair market value of the shares have risen quite a bit when compared to the strike price of the options, it is still possible to manage AMT. As your income grows, your regular tax rate will generally rise as well. Once your income has risen above the 24% regular tax bracket ($170,050 single and $340,100 married for 2022), then you may be able to exercise more ISOs with less AMT impact when compared to lower income years.
It’s important to have a plan in place to manage AMT implications. The sooner you have a plan, the greater likelihood of being able to minimize AMT. While your options may not seem like a significant benefit early in your career, we’ve seen many clients wish they had planned for the tax ramifications much sooner. If you would like some assistance in planning for your equity compensation, please reach out to schedule a call.