- posted by Dave Desmarais in the Tax Blog
In recent blogs we’ve discussed why the alternative minimum tax (AMT) is a significant risk for high-income taxpayers and strategies for addressing this risk . One of the most dangerous AMT triggers is the exercise of incentive stock options (ISOs). If you’ve been awarded ISOs as part of your compensation package, they demand special AMT-planning attention.
Are Your Options ISOs?
Before you start worrying about the AMT, you need to check whether your options are indeed ISOs — or if they’re non-qualified stock options (NQSOs), which are treated differently for tax purposes and don’t trigger the AMT.
With ISOs, you don’t owe any regular income tax until you sell the stock you purchased through exercising the option. But, for AMT purposes, the exercise creates a tax “preference” item equal to the bargain element (the difference between the stock’s fair market value when purchased and the exercise price). This amount is included in your AMT income and thus can trigger the AMT.
You may be able to take an AMT credit in the future to offset this liability. But you’ll still have to pay the AMT now, which could create a cash flow challenge because the ISO exercise doesn’t generate any cash to pay the tax.
Minimizing AMT Consequences
Why not avoid the AMT preference item by selling the stock shortly after exercising the ISOs? Because this could ultimately cost you more taxes.
When you sell stock from an ISO exercise after holding the shares at least one year from the exercise date (and two years from the grant date), the gain will be taxed at your long-term capital gains rate. However, if you sell the stock earlier, the gain will be considered compensation income and subject to your ordinary-income rate — potentially around 20 percentage points higher than your long-term gains rate.
There are, however, strategies that can help you maximize the benefit of ISOs while minimizing the AMT consequences. For example, with careful planning you can exercise just the right number of ISOs each year to hit a breakeven point between regular tax and AMT.
Disqualifying Disposition on Exercise Isn’t Always a Bad Thing
It’s also important to note that you could end up having less in your wallet even if you hold the stock from an ISO exercise properly to get the long-term capital gains treatment. It wasn’t that long ago when a lot of employees got hit by the tech bubble collapse. During the year-long holding period after exercise, companies’ stock prices plummeted — in some cases, the employees’ gross proceeds on disposition a year after exercise weren’t even the amount they paid in AMT on the exercise.
They would have been far better off had they just made a disqualifying disposition on exercise (immediate exercise and sell). This is a great example of why tax planning shouldn’t be the only consideration when performing your overall financial planning.
Comprehensive Planning Needed
The rules surrounding both ISOs and the AMT are complex. If you’ve received
ISOs, please contact us to discuss what strategies are appropriate for your particular situation. Investment, Estate, Retirement, and Tax planning should all be considered in these types of transactions, and working with a CPA who has a Personal Financial Specialist (PFS) designation is a great place to start.