If you have incentive stock options (ISOs), you might have come across the term alternative minimum tax (AMT). Basically, AMT is a way of prepaying taxes. In years when AMT doesn’t apply, you can get an AMT credit, which reduces your tax bill to reflect the prepaid amount. Here’s a simplified explanation of how exercising ISOs can lead to AMT, along with some examples.
This article is meant for informational purposes only and shouldn’t be taken as personalized financial or tax advice. It’s general information and shouldn’t be the basis for financial, tax, legal, or investment decisions.
One big downside of ISOs is that they can trigger AMT. AMT is a parallel tax calculation that ignores certain deductions and non-taxable items allowed under the regular tax system. It allows just one exemption amount that phases out with higher income. Taxpayers pay whichever is higher: their AMT or regular tax.
Under the regular tax system, exercising ISOs isn’t a taxable event. But under AMT, the bargain element (the stock’s value when you exercise minus the strike price) is included in taxable income for the year, often referred to as phantom income.
If you exercise and sell ISOs within the same year, it’s considered a disqualifying disposition, and the sale is taxed under the regular tax system. But if you hold the shares, you need to keep track of your AMT carryforward credit and dual cost basis.
There are two AMT tax rates: 26% and 28%. The 2017 Tax Cuts and Jobs Act significantly increased AMT exemptions and phase-out limits, which are set to expire in 2026.
Here’s a basic example of how exercising ISOs can create an AMT liability for a single filer in 2024 (excluding other income and the 3.8% Medicare tax):
This example is simplified for illustration. In reality, you’d also owe regular tax. For instance, if the regular tax due was $50,000, the tentative minimum tax would still be $55,718, resulting in an AMT of $5,718.
In 2024, the 26% AMT rate increases to 28% when AMTI exceeds $232,600 for single/married taxpayers. In this example, all AMT taxable income is in the 26% bracket, so the AMT due from the ISO exercise would be $55,718.
If you have regular taxable income, it would be reduced by the standard or itemized deduction, which would be added back in the AMT calculation.
There’s a silver lining with AMT: in years when you’re not subject to AMT and have regular capital gains, you might get an AMT tax credit. To recover prepaid tax, you need to track two different cost bases for your ISOs.
The regular income tax basis differs from the AMT cost basis. Continuing with the previous example:
Assume you meet the holding period for a qualifying disposition of ISOs and sell the stock for $7/share. Here’s a simplified 3-step example of the taxable gain calculations (excluding other income, the 3.8% Medicare tax, and assuming no changes to 2024 tax brackets/deductions):
Exercising and holding ISOs creates dual-basis stock. Your regular tax basis is your exercise price. The AMT basis is your exercise price plus the spread at exercise. So, your gain for AMT purposes might be less than for regular tax purposes, potentially even a loss. The difference can provide a negative AMT adjustment when the shares are sold. If you sell for less than the value at exercise, it creates an AMT loss. If the AMT loss exceeds $3,000, the negative AMT adjustment is limited to your regular tax gain plus $3,000, with the remainder carried forward.
Not every ISO holder has tax planning options. Liquidity constraints can significantly affect your choices. However, working with a stock option advisor and CPA can be beneficial as you’ll need to plan your exit and diversify your stock position.
All tax planning with ISOs involves risks. There’s a risk that tax laws will change, your tax situation will differ, and the stock might not perform as expected. This article focuses on AMT, but investment implications are important too. The exposure varies in each situation.
For more on stock option and IPO planning, consult a professional advisor.