Understand These Points About the AMT Before Exercising Your Options
firstname.lastname@example.org | May 09, 2014
We’ve previously explored how equity options
work at startups,
today we’re taking a deeper dive into certain tax pitfalls to watch out for
when exercising your options.
Although incentive stock options (ISOs) are generally
more tax friendly than non-qualifying or non-statutory options (NSOs), ISOs can
pose Alternative Minimum Tax (AMT) traps and lead to unforeseen tax hiccups.
What is the AMT?
The Alternative Minimum Tax (AMT)
is a parallel tax system that requires certain people to pay more taxes than
their just regular income tax. Although the AMT was intended to prevent those
in very high income tax brackets from using special tax benefits to pay little
or no tax, the AMT has creeped up and expanded its reach to apply to taxpayers who
don't have super high income or claim special tax benefits.
How do I know if I am AMT
This is the
trickiest part to figure out. But chances are if you are an AMT taxpayer you
know it because you have either been an AMT taxpayer or very close to it in the
past. The easiest way to think about this is that if your income hovers around
$52,800, or $82,100 for married people filing jointly, in 2014 you should run your
AMT calculations to see if you fall into AMT land. Note: These thresholds are
Basically, what taxpayers (or their accountants) have to figure
out is whether the regular tax is higher than the AMT amount and then the
taxpayer pays the higher of the two amounts. To calculate AMT, the taxpayer has to add back certain income streams and remove certain deductions. One of
those add-backs is the amount taxpayers have to include when they exercise (but not sell) their ISOs.
The ISO Trap
There are a
few potential traps.
might be pushed into the AMT regime when you exercise your ISO. Exercising your ISO can push you into AMT if the stock price
of your company's shares appreciates significantly before (rather than after)
exercise. The spread between the exercise price
and the value of the stock would be lumped into the AMT calculations.
thresholds are generally for people who make over $50k, a taxpayer can trigger
AMT exposure because one large addition on his return can nudge the taxpayer
just over the edge into AMT land. This
would be a nuisance because now the taxpayer would have to re-calculate his
taxes for AMT purposes (e.g., adding
back certain income streams like ISO income, tax-exempt bond interest, etc and minimizing
certain deductions like home mortgage interest deductions, medical expenses, misc
deductions, etc) and file the AMT Form 6251.
the taxpayer may also have to come up with the cash to pay his AMT! In essence,
the taxpayer becomes liable to pay taxes for income that he hasn’t yet fully
realized (i.e., the taxpayer received
the stocks, but hasn’t received the cash to pay the taxes due). Let’s say on
exercise date, Taxpayer’s (Bob) strike price is $5, the FMV $8 and Bob has
1,000 options. Bob’s total exercise price is $5,000 and he may have to pay AMT
on the difference between the FMV and his strike price, which is $3,000 ($8 x
1,000 shares - $5 x 1,000 shares). He may have exercised his ISO merely to
start his capital gains time clock ticking but inadvertently he may have triggered an AMT exposure AND he will have to
come up with the cash to cover it. You can see how problematic this can become when you're working for a company that's doing really well and you wait many years before exercising your options (the difference between your exercise price and the FMV of the shares at the time of exercise will be great).
trap is most likely to occur in a volatile market. To understand this, let’s continue
with Bob, who exercised his ISO at a time when the stock price was high. Let’s
say the value of his company starts to drop so he chooses to sell his shares at
$3/share. Bob will have made no economic profit in the sale since he paid
$5/share and sold for $3/share, BUT on exercise date he already paid AMT on the
$5,000 when he exercised his ISO. This AMT he paid upon exercise would generate
an AMT credit he can carryforward, but if his regular tax never exceeds his AMT
in later years, he may not be able to actually use this AMT credit he earned. If
his stock had continued to appreciate, he may have been able to soak up his AMT
credit. Long story short, Bob paid taxes on income that he never recognized and
may never get credit for those taxes he paid.
What should you do?
Congress has made it sufficiently
clear they don’t want taxpayers to avoid the AMT (so don't bother trying) but
there are a few things that can make your tax life less annoying:
early! The stock may be worth less so the difference between the FMV of the
stock and the exercise price will be smaller, thus less AMT. Added benefit:
this will get the capital gains time clock ticking ASAP. Exercise the ISO earlier in the year and sell the
shares later in the year. Any gain you have from exercising and selling the
shares would be taxed as regular ordinary income. You could have ordinary
income taxable from this sale but at least you wouldn’t have the AMT/ISO issue
and you would have cash to pay for any AMT liabilities you owe! Or you can opt to just sell
a few shares to generate enough cash to buy the
ISOs and pay any tax liabilities and keep the remaining shares as (unexercised) ISOs. This wouldn’t avoid the AMT trap but
at least you have cash to pay for your shares and your AMT taxes.
- Be prepared to fall into the AMT if you wait to exercise your options. If you exercise the ISOs but do not sell
them until a few tax years later, although the spread on the exercised options would
fall into the AMT bucket, the rest of the gain could likely be taxed as capital
gains and you may be able to soak up some of the AMT credit carryforwards to be
used later (again AMT carryforwards are beyond the scope of this post).
Which option is the best? None of these are quick fixes. It depends on
the current and future value of the underlying stock, your overall financial status
(e.g., are you an AMT payer anyway?)
and your general cash flow situation. Bottom line: If your ISO is in-the-money consult your tax advisor first (particularly
in a volatile market!) so that you are prepared to tackle these ISO/AMT pitfalls.
IRS Circular 230 Disclosure:
To ensure compliance with requirements imposed by the IRS in Circular 230, we
inform you that any tax advice contained in this communication (including any
attachment that does not explicitly state otherwise) is not intended or written
to be used, and cannot be used, for the purpose of (i)
avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing
or recommending to another party any transaction or matter addressed herein.
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