The Startup Employee’s Alternative Minimum Tax (AMT) Liabilities for Exercising ISOs
While we’ve already covered many of the tax complexities related to exercising your incentive stock options (ISOs), this particular tax implication warrants its own separate blog post: the alternative minimum tax (AMT).
ICYMI in our glossary, the purpose of AMT is to make sure that certain taxpayers are responsible for paying at least a minimum amount of income tax. Think of the AMT as if it’s a deposit: you pay taxes on your potential profits up front and, ideally, the AMT tax credit will allow you to recover some or all of this deposit later on. So when you exercise your ISOs, you are prompting an adjustment for the purposes of the AMT.
How Do I Know My AMT Liabilities Upon Exercising?
It’s key to reiterate that AMT is a type of income tax – meaning it’s different from your ordinary income tax [1] so it has its own unique tax rules and liabilities.
When exercising ISOs, you will be liable to pay either the AMT or the ordinary income tax. Which one you’re responsible for is dependent on when you sell your shares after exercising. Let’s break this down…
There’s one path that does not require an AMT adjustment:
If you exercise your ISOs and sell your shares in the same tax year, then you do not have an adjustment for AMT. However, you will still be liable to pay ordinary income taxes on that sale. Sometimes, the ordinary income tax rate can be higher than the AMT rate.
However, there are two paths that require an AMT adjustment:
- If you exercise ISOs and do not sell them in the same tax year, then the difference between the grant price (the exercise price of your stock options) and their fair market value (FMV) upon exercising will be taxable income in the calculation for your AMT. This amount will increase your AMT liability.
- If you exercise your ISOs before an IPO happens, you will trigger AMT if the shares are not sold as part of the transaction or sold within the same year. You will need to have liquid funds to pay this tax – within the 90-day post termination exercise window – after leaving your job.
All of this AMT information is applicable at a federal level, but there are some individual states that have their own version of the AMT or their own AMT rate. While we will cover this in a later post, we encourage you to speak with a tax professional who is familiar with your state’s AMT regulations.
So How Do I Decide When to Exercise and When to Sell?
The answer to this question depends on your unique situation and priorities.
ISOs can grant you tax advantages if you buy shares early enough in the year and if you take AMT into consideration when deciding if you will sell before the year ends.
In this scenario, if your company allows, you can either:
- Sell enough ISO shares to cover both the initial cost of purchasing the stock and any relevant taxes, and then hold onto the rest of the shares, or
- Exercise your options at the beginning of the year in order to give yourself some time to watch the stock’s value. You can use this information to decide if you want to hold the shares after that tax year ends or if you want to go ahead and sell them during the same tax year in order to avoid AMT.
Nevertheless, it’s helpful to get an estimate of your AMT before you exercise, as it could be a significant amount of money that may otherwise catch you off guard.
To calculate the AMT for your ISOs, take the difference between the FMV at the time of exercise and the exercise price for your options. The resulting number is your AMT’s spread; this amount is treated as income and can increase your AMT liability.
If you need some additional support – before you consult with a tax professional, of course – IRS Form 6251 is one tool to help you determine if you’ll be held liable for paying AMT after you exercise your ISOs.
Peeking Into the Fine Print
When you sell your shares, you might be taxed at a capital gains tax rate if you held the shares more than one year from exercise and two years from grant. This rate is only relevant if the value of your shares at the time of sale is higher than when you purchased them:
Through all of this, keep in mind that the AMT was not designed for lower and middle-income taxpayers. Although it was designed to target higher earners, there are still exemptions in place for all ISO holders – yes, this includes high earners!
Tell Me More About These Exemptions!
The AMT exemption is equal to an amount that taxpayers are allowed to deduct from their alternative minimum taxable income before calculating their AMT liability.
There is a phasing out process between getting the full AMT exemption and getting no exemption at all. These thresholds change a little from year to year, but let’s use 2021 as our example.
In 2021, the AMT exemption amounts started out at
- $73,600 for singles or heads of household,
- $114,600 for married people filing jointly or for surviving spouses, and
- $57,300 for married people filing separately.
That same year, the following amounts marked the threshold where the exemptions completely phased out:
- $818,000 for singles or heads of household,
- $1,505,600 for married people filing jointly or for surviving spouses, and
- $752,800 for married people filing separately.
These amounts reflect the fact that the AMT exemption amount is reduced by one dollar for every four dollars that the taxpayer’s income exceeds the alternative minimum taxable income threshold for their filing status.
In 2021, the specific thresholds when the exemptions began to phase out were:
- $523,600 for singles or heads of household,
- $1,047,200 for married people filing jointly or for surviving spouses, and
- $523,600 for married people filing separately.
Every year, you are required to calculate both your ordinary income tax and your AMT. You will then pay the higher tax of the two.
I See Why AMT Needed Its Own Separate Blog Post…
As is abundantly clear, the alternative minimum tax is incredibly complicated. This outline of AMT-related tax implications will be helpful when you consult with your tax advisor and financial planner throughout the process of exercising your ISOs.
Don’t forget: the decisions you make about your holding periods have significant impacts on your tax responsibilities – and they cannot be undone or redone – so you want to make sure you get it right the first time!
[1] Ordinary income tax describes any type of income that is taxed at the United States’ marginal tax rates. This income includes wages, salaries, tips, and commissions. This term is also referred to interchangeably as regular income tax. See more in our glossary.
