Incentive Stock Options – AMT Overview

Jeff Branson, MBA, CFP® – Jeff is the founder of Branson Financial Planning. He spends his time acting as a personal CFO to households across the United States. He believes that financial advice should be clear, objective, and delivered in a fiduciary manner. When he’s not working, Jeff spends time exploring beautiful Maine with his girlfriend Bianca and his golden retriever Mavrick.

In the late 1960’s there were about 155 high income families that were paying zero federal income taxes due to a number of legal tax credits and deductions. Congress at the time thought that wasn’t fair and decided to add in an additional way to calculate your federal income tax. This new calculation resulted in the Alternative Minimum Tax (AMT).

The AMT is not a double tax, which many seem to believe. It is an alternative way you calculate your federal income tax. It runs parallel to the regular federal income tax. You are required to pay the greater of AMT or your regular federal income tax. Most tax prep software will calculate both automatically to let you know if you’re subject to any AMT. The AMT only comes into play in specific situations such as exercising incentive stock options (ISOs).

AMT Calculation

The AMT is calculated on IRS form 6251. This is a fair warning as your eyes might gloss over trying to figure out what most of the items mean.  Most of the items listed are very ‘one off’ and don’t occur often. Here’s a quick overview of the form:

  1. Start with Taxable income from 1040
  2. Add Back either the standard deduction or if itemizing, add back Schedule A, line 7. Why do we add this back? The AMT has its own exemption amount given later.
  3. Add in preference items. These are the items the AMT was brought into place for. You might go your whole life without realizing most of these activities. If you have ISOs though, you need to add in on line 2i the bargain element of the amount you exercised.
  4. Combine 1 -3 will give you your AMTI, alternative minimum taxable income.
  5. Subtract your exemption amount. This will vary depending on your AMTI and filing status. The exemption is phased out at higher incomes.
  6. After you subtract any exemption amount, you calculate your tax using the applicable tax rates. You might have an additional layer of calculations to perform if you realized any long-term capital gains or have any qualified dividends. These are both taxed at normal rates for AMT purposes but could change how much AMT you are required to pay.
  7. The result is your tentative minimum tax. Compare this number to your 1040 regular income tax. If your minimum tentative tax is more than your regular income tax, you pay the difference as AMT on your schedule 2, 1040.

AMT Exemption

The exemption for AMT is much larger as compared to the standard deduction under the regular federal tax; the exemption being $73,600 for single filers in 2021 and $114,600 for joint filers in 2021. This helps with the burden of any preference items that get added back such as ISOs.

AMT Tax Rates

The AMT has 2 tax rates: 26% and 28%. The 26% rate is used against AMTI (after the exemption) up to $199,900 for single and joint filers. Any amount over is taxed at 28%. You’ll see a big difference if you compare this to the regular federal income tax which starts at 10% and progresses up to 37%.

Avoiding AMT

Just because you exercise your ISOs does not mean you will automatically pay AMT. You only pay AMT if your federal income tax is less then AMT. You then pay the difference. You don’t have to pay any AMT if you exercise ISOs and the added tax preference (from the bargain element) amount keeps your AMT less than your regular tax.

AMT Credit

Having to pay the AMT is considered a prepayment of tax. You (once again) might think you are double paying tax if your general strategy is to hold onto the shares long enough to pay long term capital gains over the strike price (also called a qualifying disposition). To recoup this prepayment, you are given a tax credit in future years. The calculation of the credit is complex and is done on IRS form 8801 (and carried over to your 1040 – schedule 3). Depending on your tax situation, you might not be able to recoup the AMT you paid in a prior year. Any unused credit is carried forward to future years until completely used up. You do not need to dispose of your exercised ISO shares to recover the credit, but the disposal does accelerate your AMT credit. The credit is available to use in years where your AMT liability is LOWER than your regular tax liability.

Final Words

The most difficult part when dealing with ISOs is the phantom income from the ISO bargain element that subjects you to AMT. You could be in a pinch if you didn’t plan properly for the resulting tax bill. Holding your options through a calendar year is the only way to capture the favorable tax treatment they offer.  

You can try to strategize to get your AMT under your regular federal income tax, but that isn’t always possible when you have highly appreciated options. Tax projections can save you from a large, unexpected tax bill come April 15th.

As always, remember to consult with your tax, legal, and investment professionals.