AMT and ISOs
The Alternative Minimum Tax (AMT) is an alternative calculation of your income tax liability, designed to reduce the ability for high earners to pay low average tax rates. As the name suggests, AMT is a tax minimum, so you’ll have to pay either AMT or your regular income tax liability, whichever is higher. The specifics of AMT are beyond the scope of this writing, but may be expanded on in a future post.
Why Does It Matter To ISO Holders?
AMT is relevant for incentive stock option (ISO) holders because of the lack of regular tax liability on the bargain element (the spread between the exercise price and the FMV at exercise) when ISOs are exercised. This contrasts with non-qualified stock options (NSOs), which face ordinary income tax on the bargain element at exercise. The IRS doesn’t really want to wait for you to sell your ISO shares to get paid, so it includes an AMT adjustment on ISO exercises to get some taxes earlier. The AMT paid on an ISO exercise is designed to be a prepayment of taxes that gets recovered in the future, but there are things to consider when triggering AMT with an ISO exercise to ensure you’re able to recover the extra taxes paid and don’t face any surprises down the road.
The real thorn in your side is managing the tax credit generated every year. While many other AMT preference items (like the SALT deduction) are exclusion items only relevant in that tax year, AMT on ISO exercises is a deferral item that generates a future minimum tax credit (MTC). Your MTC needs to be calculated every year until the credit is depleted (unless you don’t mind overpaying taxes). With multiple grants, ongoing exercises, and stock sales, it gets messy.
Avoiding AMT when exercising ISOs prevents a multi-year headache because taxes aren't prepaid and an MTC isn't generated. Additionally, not prepaying taxes is better from a time value of money standpoint. As a result, avoiding AMT is often a top priority for ISO holders, but sometimes the “avoid AMT at all costs” approach can actually be detrimental overall. Many factors should be considered when weighing the decision to trigger AMT: how many shares can be exercised without triggering AMT, the "educated guess" timeframe to an IPO or acquisition, predicted future rise in 409A valuation, expectations of leaving the company, and more. On the flip-side, many people don’t even think about AMT when exercising their ISOs and get a very unpleasant surprise the following April.
You’ve Triggered AMT, Now What?
Triggering AMT with an ISO exercise creates a dual-basis asset – one for regular tax and one for AMT. Keeping track of both is necessary to ensure you ultimately recover any prepaid taxes and don’t end up overpaying.
Every year, you’ll need to calculate your AMT, file Form 6251, and compare your AMT to your regular income tax liability. You also must file Form 8801 every year to track and carry forward any unused minimum tax credit (MTC) generated by your ISO exercise.
You might not need to wait to sell your ISO shares to start recovering your tax prepayment. Each year following the year you exercise, your MTC reduces your tax regular tax liability. However, your allowable MTC is limited to the amount your regular income tax liability exceeds your AMT liability. In other words, you can’t use the MTC to pay less than your AMT in a given tax year.
If you’re a high earner in the tech space, your allowable MTC will likely be small or nonexistent – especially if you exercise ISOs each year or have substantial itemized deductions. In that case, selling your shares may be the only realistic way to recover your prepayment.
A Few Strategies to Consider
The strategies here are meant to get you thinking about possible action plans and are not recommendations. Many variables in your company and personal situation aside from the AMT consideration will determine the course of action most suitable for you. I’ve recommended variations of these (and others) to different clients based on their unique needs. Speaking with your financial and tax advisors before implementing an exercise strategy can prevent costly errors.
To the Limit
Exercising the maximum number of ISOs without triggering AMT is a simple strategy because it avoids the ongoing considerations around AMT completely. The downside is that many ISO holders will be limited in the number of shares they can exercise this way, a problem exacerbated with a large number of ISOs and a large bargain element.
NSOs and ISOs
If you have NSOs along with your ISOs, you can exercise some NSOs to increase the number of ISOs you can exercise without triggering AMT. The main downsides here are an increase in regular tax liability due to the NSO exercises and additional risk due to more money invested into your company’s stock (I consider taxes owed on an exercise part of the investment outlay). If your company allows cashless exercises (relatively rare for private companies) or you’re able to sell some of your shares in the private secondary market, exercising and selling some or all of those NSOs immediately de-risks your investment by reducing your cost to own the shares. You can more easily execute this strategy if your company is already public.
You can do the same with ISOs by creating a disqualifying disposition and effectively turning those ISOs into NSOs, but the loss of the tax advantages often makes this strategy one to avoid, especially if there are other alternatives.
Trigger Some AMT
Triggering AMT with an ISO exercise isn’t necessarily a bad thing. It could be worthwhile to deal with AMT in order to start the long-term capital gains (qualifying disposition) clock and potentially have the MTC to recover annually. And sometimes, AMT is unavoidable when exercising any number of ISOs at all.
The AMT adjustment on ISO exercises is a relatively simple concept in theory, but in practice can be complicated and confusing, and often puts tens or hundreds of thousands of dollars at stake. Many factors come into play when deciding how many shares to exercise, when to exercise them, and how much AMT to trigger (if any). Working with financial and tax advisors who understand the ins and outs of ISOs and AMT is critical to ensure you’re able to make the most out of your equity compensation and don’t inadvertently throw money away by overpaying taxes. Want to talk about your ISO exercise strategy? Send me an email or schedule a time to talk.