May 7, 2021
If you have stock options (ISO, NSO or RSU), chances are you’ve heard about Alternative Minimum Tax. But what exactly is it and how is it calculated? And more importantly, how does it affect your monetary gains?
Simply put, AMT is a type of income tax, but it’s different than your ordinary income tax. Let’s look at some specifics:
AMT is a different way of calculating your income tax obligations. Its purpose is to ensure that everyone, especially high earners, pay an appropriate tax amount. You will either pay the alternative minimum tax or pay your ordinary income tax rate. Naturally, there are pros and cons to each.
If you pay the AMT, many traditional tax breaks and incentives are not available, which means your taxable income may be higher. However, AMT usually makes more financial sense in the following circumstances:
As a general rule, the majority of AMT taxpayers have at least $200,000 in taxable income, as shown below:
If you make more than the AMT exemption amount, you will need to pay the higher of the two tax options. The good news is that if you do have to pay AMT, that amount becomes a potential tax credit that you can subtract from a future tax year.
AMT is based on your alternative minimum taxable income. In a nutshell, your AMT is your regular income minus some personal deductions (such as local or state sales tax). If you have an ISO, you’ll also need to factor in the spread between the price of exercising your ISO and its fair market value at the time of exercising.
Once you discover your taxable income, you can determine your tax rate, as shown below:
Calculating your AMT income can be a complicated process and is usually best left to a tax professional.
AMT becomes more of a focus if you exercised incentive stock options but didn’t sell them in that same tax year. The difference between the price when you exercised your stock options and their fair market value upon exercising is considered taxable income when calculating AMT, which will drive up your tax liability.
For example, if you exercise 500 shares at $5 each and they’re actually worth $10 each, you’ll need to add $2,500 to your taxable income to the AMT tax calculation. This is not the case for ordinary income taxes (taxes you usually pay on your salary).
If you sell ISO shares in the same year in which you exercised them you won't be required to pay AMT, but you will need to pay ordinary income taxes on the sale and it could be at a higher rate than AMT.
One way you might avoid the AMT pitfall is by selling just enough ISO shares to cover the cost of purchasing the stock in the first place and any applicable taxes (and keep the remaining shares for yourself).
Another strategy is to exercise your options toward the beginning of the year. You can avoid AMT by selling your shares before year’s end. But in the meantime, you can closely watch your stock’s value to decide whether or not to hang onto them. If you choose to keep them, you might qualify for capital gains treatment.
There are a lot of moving parts to the AMT rule, especially for high income earners that exercise incentive stock options during the tax year. Calculations can be complicated and highly detailed, which is why it’s prudent to consult with a tax professional who specializes in complex cases like AMT.
At YearEnd, we work specifically with employees of startup companies who may have benefits like ISOs and need an expert on their side. Contact us today to see how we can help you understand your tax obligations and help you maximize your deduction opportunities.