A little ditty on... the Alternative Minimum Tax and Incentive Stock Options.

If you're reading this... it's because you have Incentive Stock Options and you're interested in better understanding the tax implications of exercising the options. Or maybe you have Non-Qualified Stock Options and you love learning? Or maybe it's something else? We don't discriminate... but we also don't want to waste your time.

What are we talking about today?

We're talking about the fact that the bargain element on your ISOs can bump you into a position where you are stuck paying an Alternative Minimum Tax adjustment. That sounds like something the average person will never care about. And yeah, that's a fair characterization. But if you're lucky enough to care about it (if you have ISOs), then today you should tap into the version of yourself who is ready to learn a thing or two about our tax system.

Two quick refreshers then we're moving on

The Bargain Element is the difference between the fair market value (FMV) of the shares at the time you exercise the option and your strike price. So if you exercise the option at $10 per share FMV and the strike price is $2... the bargain element is $8 multiplied by however many options you exercise. E.g. if I have 20,000 options and I exercise them all, the bargain element would be $160,000. So yeah, it's obvious why I would love to NOT pay taxes on that... (because it's a lot of money).

ISOs vs. NSOs

Without going too deep here... ISOs get better tax treatment. The great thing about ISOs is that you don't have to pay taxes on the bargain element when you exercise the option. With NSOs, the bargain element gets taxed as ordinary income and that can mean a sizable tax bill even before the shares have any value. (If all of this is new to you, start with this article). There are a few other differences, but this one is most germane to today's topic.

So you're saying the ISO bargain element goes tax-free?

Um, not quite... There's a catch. And it's called the Alternative Minimum Tax adjustment.

Over the course of this post

We're gonna cover what AMT is, why it exists, when you might be stuck paying it, how it relates to ISOs, how you can actually get the tax adjustment BACK over time, and a nifty little strategy for avoiding ISO bargain element taxes entirely (it doesn't always fly, but when it does... it's glorious).

What is the Alternative Minimum Tax (AMT) and why does it exist?

AMT was originally designed by the treasury to keep super-rich people from avoiding 100% of taxes through deductions, credits, etc... The real story (this is not a joke) is that 155 millionaires avoided paying taxes for a few years. So in 1969, the government was like "oh I don't think so" and they created this second system of calculating taxable income that removed a bunch of the deductions and credits that scheming richies could use to reduce their taxable income, effectively guaranteeing a minimum tax rate for taxpayers earning over a certain amount.

The government also was like "we're NOT gonna index this to inflation" and for like, the next 45 years, the people who actually got hit the hardest by AMT were the middle class. Nice one. (Congress passed legislation in 2015 that attempts to fix this).

When might you find yourself paying AMT?

If your income is above the annual exemption ($73,600 in 2021 for single filers, 114,600 for married joint filers)... the AMT calculation will have to be made. You won't necessarily be paying AMT, but your accountant or tax software will have to run the numbers to check.

If there is an "event" that would subject a particularly large portion of (potential) earnings to an especially low tax rate (or no tax rate at all), then it's very possible that you will, in fact, be paying an AMT adjustment.

Is it AMT? Is it an AMT "adjustment"? What's the difference and why is this so complicated?

The simplest way to make sense of this is with pictures. First, let's look at how regular tax liability is calculated, and then we can compare that to the AMT calculation. I keep mentioning an "adjustment" because if the AMT liability is higher than the regular tax liability, the difference gets added to the regular amount (so the regular amount gets "adjusted" by the difference in AMT). Okay, fewer words, more pictures.

How your regular tax liability is calculated

Remember: I'm not a tax professional. But here's what I've learned (this is gonna be, at the very least, directionally correct. I'm trying to make a point, not write a textbook).

Now let's compare this calculation to the AMT calculation

You'll notice that things are basically the same until we get to that taxable income number... then stuff starts getting added back (MOST NOTABLY... the capitalized "preference items", which include things like the bargain element of your exercised stock options. I'll make this point more aggressively in a moment.) The AMT tax rate is either 26% if AMT income is below $197,900 and 28% if your AMT income is above that threshold.

What happens if the AMT tentative tax is higher than the regular tentative tax?

The difference between those two is the "AMT adjustment" and it gets added on top of the regular tentative tax.

So if we zoom back out... the whole thing looks like this

This matters to you because the ISO bargain element is included in the list of "Preference Items" that get included in the AMT Income calculation

So if your bargain element is gigantic, your AMT Income (AMTI) get ratcheted up quite a bit and an adjustment is all but unavoidable.

Like I said, I am sure that I got this "directionally" right. If you're looking for exact numbers, please rely on your tax software or a tax professional. OR... there's this company called SefFi that, if you sign up for a free account, has some very useful tools for calculating these numbers. I'll get to why it's worth going through the calculation in a sec.

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AMT Credit and the "cross-over" calculation

Taxes are basically a bottomless pit and I am not here for it. There's a reason accountants are so expensive. But, I will leave you with two things to be aware of. The first is the AMT credit.

The AMT credit is dependent on two conditions being met:

1. you have had to pay an AMT adjustment before
2. there are future years when your regular tax liability is higher than your AMT tax liability

So in the simplest terms, if you pay $10k additional tax dollars in year 2021 through AMT, and you DON'T get hit with AMT in 2022... you can get a tax reduction on your 2022 taxes through the AMT credit.

Last thing: there is a way to exercise ISOs tax-free with the AMT cross-over calculation

This is an especially fun little trick. Here's how it works:

Conceptually, you avoid AMT adjustments if your AMT Tentative Tax is lower than your Regular Tentative Tax.

So, if you exercise ISOs in such a calculated way that your bargain element keeps your AMT Tentative Tax juuuuuust underneath your regular taxable income, you can get away with paying $0 in taxes when you exercise your ISOs. So, with a little math (and help from your accountant) you can exercise just enough to be equal to the regular tax.

This is a good strategy if you're only looking to exercise a small amount of options. Like I mentioned above, SecFi has good free tools for this stuff (they have a dedicated AMT cross-over tool).

Alrighty folks, there you have it

A quick explainer on how ISOs might impact your overall tax burden by triggering an AMT adjustment. If you made it this far, I tip my hat to you.