Alternative Minimum Tax: What to Be Aware of
Alternative Minimum Tax: What to Be Aware of
There was a period of time where, apparently, some individuals were using so many deductions, credits and tax loopholes that they were paying almost nothing in taxes. Enter the Alternative Minimum Tax, created in 1969.
Essentially, what this did is created a 2nd tax code, to be used in conjunction with the standard tax code, to determine which of the two creates the higher tax owed, which is what will actually be applied to the taxpayer. This way, if a high-income earner manages to drastically reduce his or her tax liability through various tax strategies, the AMT is there to say “not so fast”. Just as the name implies, it is an alternative tax code, used to ensure all income earners are paying at least some taxes.
Since the 2017 Tax Cuts and Jobs Act (TCJA) raised AMT exemption amounts, fewer people need to worry about AMT applying to them. However, it’s still something many need to be aware of.
In a nutshell, here is how the AMT works:
Determine taxable income using the regular tax system
Add back preference items that are normally deductible, but not deductible under AMT. These are items such as SALT deductions, itemized deductions, and Incentive Stock Options
After all preference items are added back, AMT is calculated
Subtract the AMT exemption from that amount, and then apply the AMT tax rates
If AMT tax liability is higher than the normal tax liability, AMT will be used
Again, most people will not need to worry about AMT. But there is one preference item that can often trigger AMT without people realizing it, and that item is Incentive Stock Options.
For a quick recap, ISO’s (Incentive Stock Options) are shares of a company that are given to a valuable employee, at a particular price. The employee can exercise their right to own those shares, and then sell those shares when they choose to.
When this happens, when the employee exercises their right to own the shares, is creates two completely different events in terms of the standard tax code vs AMT:
Regular Tax Treatment of ISOs
When you exercise an ISO, you don’t pay tax right away on the “spread” (the difference between the stock’s fair market value (FMV) at exercise and the strike price you paid).
If you hold the stock for at least 1 year after exercise and 2 years after the grant date, you get favorable long-term capital gains treatment when you sell.
If you sell earlier, it’s a disqualifying disposition and the spread is taxed as ordinary income.
So, in the regular system, exercising doesn’t create immediate income — only selling does.
AMT Treatment of ISOs
The “spread” at exercise (FMV – exercise price) is treated as income for AMT purposes — even though you haven’t sold the stock and haven’t received any cash.
This spread increases your Alternative Minimum Taxable Income (AMTI).
If this pushes you above the AMT exemption amount, you’ll owe AMT.
As a quick example, imagine you work for ABC Company, and they grant you 1,000 shares of their stock, at a price of $50. You decide to exercise these shares when they’re trading at $100, double what they were granted to you at. This creates a spread of $50,000.
Using the regular tax system, no tax is owed at this point because you have only exercised the stock, not actually sold them. But under AMT rules, that $50,000 counts towards AMT income, and could potentially trigger AMT tax in that year.
This is what often surprises people who exercise ISO’s. They meticulously follow all the regular ISO rules to avoid paying income tax on the spread, only to discover that they triggered AMT instead.
Main Takeaway:
Even though AMT won’t apply to most people, it may apply to you, especially if you’re exercising ISO’s. Before you exercise your shares, consider working with a professional to determine if the exercise is likely to trigger AMT. If it is, you may want to consider strategies such as exercising fewer shares in any given year and spreading it out across multiple years.
Remember, every dollar that you legally avoid giving to the IRS is another dollar that you keep in your pocket. It is a vital part of wealth building and financial planning, and should never be overlooked.
Ryan Page, CFP®, MBA®
Office & Text:720-826-1092
Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.
This information is not intended to be a substitute for individualized tax advice. We suggest that you discuss your specific tax situation with a qualified tax advisor.
This is a hypothetical example and is not representative of any specific situation. Your results will vary. The hypothetical rates of return used do not reflect the deduction of fees and charges inherent to investing.
