Alternative Minimum Tax (AMT)

AMT often comes as a surprise to those who exercise but do not sell their shares. A tax obligation arises even though nothing is sold. Some have even termed this the AMT trap. AMT affected 5 million Americans in 2017 and after some changes to the tax code, it was estimated to affect 200,000 Americans in 2018.

As a warning, AMT is complicated, so please make sure to consult a tax professional if you are in a position where you could qualify for AMT. This article also assumes you have read our article on the basics of SBC. If you have not, I encourage you to start there. If you exercise an ISO, the spread gain, or difference between your current Fair Market Value (FMV)) and your exercise price (or strike price), may qualify for an AMT adjustment. If you do qualify, you will be required to pay an AMT tax by the next tax filing date. Your AMT tax obligation will usually be a 26% – 28% federal tax on the spread gain depending on your income tax bracket plus an additional state AMT rate if you live in California, Colorado, Connecticut, Iowa, or Minnesota. Here is a brief example of how money flows:

• You pay money to exercise your ISOs
• If you trigger AMT, you will pay a tax on the difference between your current FMV and the exercise price
• When you sell your shares and assuming they appreciated, you will pay tax on the difference between your sale price and the FMV referenced in the prior bullet

AMT can be particularly burdensome because option holders want to qualify for long-term capital gains tax, and in order to do so, they must meet the requirements for a qualifying disposition by holding their shares for both one year after exercising and two years from the grant date. Triggering AMT can create a costly taxable event with no proceeds to cover it. There are a few ways in which you can manage AMT:

• Exercise your options only when you can sell some of your shares at the same time, which will give you profits to cover your AMT tax burden
• Exercise a portion of your options each year so that you either do not trigger AMT or have a more manageable tax burden each year
• Early exercise your options at the grant date so that the spread gain will be zero, so you will not trigger AMT
• You can take out financing at the time of exercise to cover your exercise costs and the subsequent AMT obligations

The original purpose of AMT was to ensure that more exotic income streams are considered in the eyes of the IRS. Your paper gain from the exercise of ISOs contribute to your AMT taxable income, and other sources of income do as well, such as tax-exempt private bonds and foreign tax credits. The 2017 Tax Cuts and Jobs Act introduced two measures which reduce the magnitude of AMT. The first was to raise the annual exemption amount, and the second was to increase the annual income which triggers the exemption to phase out.

In 2020, the exemption amount was $72,900 for single individuals and $113,400 for married couples. If the spread gain on the ISOs you exercised in that year is under that amount, you are exempt from AMT. Additionally, this AMT exemption disappears once your AMT taxable income is above a certain amount. In 2017, this figure was $120,700 for single individual sand $160,900 for married couples, and in 2020, the threshold increased to $518,400 for single individuals and $1,073,000 for married couples.