"People who exercise ISO grants don't usually pay federal tax upon exercise." I saw this statement in a client's equity compensation software while walking them through an ISO exercise.
In my opinion, this statement is the worst kind of true - technically true. There's no federal tax withholding requirement when exercising ISOs, so you likely won't pay (or withhold) taxes when you exercise ISOs. But that doesn't mean you won't owe taxes as a result of your exercise. I've met enough people stuck with tens of thousands or even hundreds of thousands of dollars of unexpected taxes from ISO exercises to know this is a common and potentially devastating misconception.
There might be another "technically true" piece of that statement as well: "federal tax". While it's true that ISO exercises don't increase your "regular" federal income taxes, they can increase your alternative minimum tax (AMT) calculation. For some reason, a lot of people seem to distinguish alternative minimum tax (AMT) from federal income taxes. Although AMT and "regular" federal income taxes are separate, parallel tax calculations, AMT is still part of your federal income tax liability at the end of the day.
A Quick Refresher on AMT:
AMT is a parallel tax system that adds back a number of items that were deducted or not included in regular income. It's calculated alongside your regular tax liability but only increases your tax liability if your AMT calculation is higher than your regular tax calculation. The vast majority of taxpayers don't need to worry about AMT for most of their lives, but people with ISOs should know that ISO exercises are a common AMT trigger.
In short, AMT starts with taxable income and adds back and subtracts out various items, called adjustment items and preference items, to get to AMT income (AMTI), then has a graduated 26% and 28% tax schedule applied. The result is AMT (technically "tentative minimum tax", but pretty much everyone calls it AMT). If your AMT calculation is larger than your regular tax liability, you pay AMT instead of your regular tax (hence alternative minimum tax). Larger ISO bargain elements mean bigger additions to AMT, which increase the likelihood of owing AMT.
How ISO Exercises Impact Taxes
When you exercise ISOs, the bargain element (excess of the FMV at exercise over your exercise price) isn't considered income for regular tax calculations. However, the key phrase here is "regular tax". While ISO bargain elements aren't included in income for regular tax, they are income for alternative minimum tax (AMT) purposes. Specifically, ISO bargain elements are positive adjustments to AMT, which increase AMT income and can result in additional taxes owed.
For example, say you expect your regular tax liability this year to be $20,000, with an AMT (tentative minimum tax) calculation of $17,000. You'd owe $20,000 in federal taxes - the AMT calculation has no impact since it's less than $20,000. Now take the same situation but you exercise enough ISOs to increase your AMT calculation by $8,000 to $25,000. Your regular income tax calculation would still be $20,000, but since your AMT calculation is now higher, you owe the AMT amount instead, or $25,000.
The Downside of No Tax Withholding
I believe that the lack of automatic or mandatory tax withholding when you exercise ISOs further fuels the misconception that no taxes are owed. Tax withholding is mandatory when your RSUs vest or when you exercise NSOs, so the absence of tax withholding on ISO exercises can definitely set the wrong expectations. Couple that with the fact that the vast majority of taxpayers will never be impacted by AMT unless they exercise ISOs, and it's easy to see how people make the mistake of thinking they won't owe any taxes on their ISO exercise.
The Complexities of AMT Calculation
Now that you know your ISO exercise could increase your tax bill, you might be wondering how much more you can expect to owe. Unfortunately, AMT is impossible to estimate without knowing your specific situation and being able to compare it to your regular tax liability. For most people, there's some amount of ISO bargain element that won't trigger AMT, but that threshold can be as low as $0 (already triggering AMT) or above $100,000 in some cases.
This might be another reason why there's no standard withholding requirement for ISO exercises. The same exercise for two different taxpayers can have a wildly different tax impact, depending on their normal income situation and the AMT-impacting actions they make throughout the year.
If you have any questions or would like to discuss your situation in more detail, please don't hesitate to reach out or schedule a time to talk.