Incentive stock options, or ISOs, can be a lucrative employee benefit. This is particularly true at startup companies, which frequently offer stock options as a form of alternative compensation to make up for under-market salaries. However, when you exercise your stock options, the IRS may treat the difference between the shares’ fair market price and your strike price as taxable income. While this will not apply to your income taxes, if the resulting gain is large enough it can trigger the alternative minimum tax (AMT), driving up your tax bill for the year. We’ll discuss the full details.
A financial advisor can assist you in creating a tax strategy to minimize your taxes.
What Is the Alternative Minimum Tax?
The alternative minimum tax (AMT) is a minimum tax rate that applies almost entirely to people with high incomes.
The U.S. tax code has a wide range of deductions and credits that taxpayers can use to reduce their taxes. Credits apply by directly reducing the tax bill that you owe the government; $1 in credits reduces your tax bill by $1. Deductions apply by reducing your taxable income; $1 in deductions reduces the money on which you can be taxed by $1.
Credits and deductions can reduce your tax bill significantly, in some cases down to $0 or below. As a result, Congress passed the AMT to act as an effective floor for higher-income households. After a certain income, the IRS charges you a minimum tax rate regardless of most deductions and credits.
In 2023 the alternative minimum tax cutoff is $81,300 single/$126,500 married. To calculate the AMT you take the difference between your income and the cutoff. For example, if you earn $100,000 as a single-filer, you would calculate AMT on $18,700. Then multiply that by either 26% or 28% (the higher rate applies to higher incomes). This is your alternative minimum tax.
If the alternative minimum is higher than your income taxes, you pay the difference. If the minimum is less than your income taxes or if you earn less than the cutoff, the alternative minimum tax does not apply.
How Incentive Stock Options Trigger Alternative Minimum Tax
While incentive stock options are tax-advantaged, they do have one drawback. When you exercise your options and purchase shares from your employer, the IRS calculates what is known as the “bargain element.” This is the difference between the strike price on your option, the amount that you pay your employer to receive these shares, and the stock’s fair market price as of when you execute the option.
For example, say you have an ISO with a strike price of $10. This means that you can buy shares of company stock from your employer for $10 per share. On the day you execute this option, the company’s stock is trading for $50 per share. Your bargain element is $40 per share.
Alternative Minimum Tax – Example
To see this in action, let’s say you still have an incentive stock option plan with a strike price of $10. The company’s stock is selling for $160 per share so you exercise your option and buy 1,000 shares of stock. Your bargain element here is $150,000 (the difference in prices of $150 times 1,000 shares).
You earned $80,000 in income over the past year. Ordinarily, you would calculate your AMT liability as follows:
- Income – $80,000
- Alternative Minimum Tax Exemption – $81,300
- Income ($80,000) – Alternative Minimum Tax Exemption ($81,300) = 0
Since you make less than the AMT exemption, the tax does not apply to you.
However, in the year when you execute your incentive stock options, you would calculate your AMT liability as follows:
- Income – $80,000
- Bargain Element – $150,000
- Income ($80,000) + Bargain Element ($150,000) = AMT Income ($230,000)
- AMT Income ($230,000) – AMT Exemption ($81,300) = Taxable AMT Income ($148,700)
- AMT Tax Rate (26%) x Taxable AMT Income ($148,700) = AMT Tax ($38,662)
Although you don’t include the bargain element in your income taxes, you do apply it for the purposes of calculating your alternative minimum taxes. Since you always owe the higher of your income tax rate or your alternative minimum tax rate, if you paid less than $38,662 in income taxes you will have to make up the difference.
How to Avoid Triggering the AMT
As a threshold matter, the best way to manage this is by finding what is known as your “crossover point.” This is the amount of income between what you earned this year and what would trigger an alternative minimum tax payment.
For example, say you earned $100,000 in the past year. After your AMT exemption ($81,300), this would give you $18,700 of applicable income. At 26%, this would come to $4,862 in taxes. As long as you paid more than $4,862 in income taxes over the course of the year, you will not owe the alternative minimum tax.
Now, let’s say that you still earned $100,000 and you paid $26,000 worth of income taxes last year. You will owe the alternative minimum tax once your AMT liability is greater than your income tax payment, so once your AMT liability is greater than $26,000. Assuming you pay taxes under the lesser 26% AMT bracket we would calculate your crossover point as:
- AMT Income x 26% = $26,000 The alternative minimum tax rate you would need before you begin to owe additional taxes
- $26,000 / 26% = AMT Income ($100,000) The amount of taxable income you would need in order to owe $26,000 in alternative minimum tax
- AMT Income + Exemption = Crossover Point
- $100,000 + $81,300 = $181,300 The total amount of income you would need in order to have $100,000 in alternative minimum tax income
If you paid $26,000 worth of income taxes over the past year, you would need to earn $181,300 before your alternative minimum tax liability would begin to exceed your income tax payments. This means that your crossover point will occur after another $81,300 in earnings.
Limits to the Crossover Approach
If crossover planning is not an effective approach, you can always manage your taxes through a combination of long- and short-term sales. From a tax rate standpoint, you are always better off holding your shares for more than 12 months. However, if you cannot avoid triggering a significant tax bill, short-term shares can generate needed cash.
Take out additional shares with the express purpose of selling them to pay any associated taxes. It will cost more than holding these shares in the long run but may be a better option than triggering a large, unfunded income tax liability.
When you exercise your options under an incentive stock option, the IRS may apply this to your alternative minimum tax obligations for the year. A good way to avoid this is by structuring your options to remain under your annual cutoff point.
Tax Planning Tips
- You may find it helpful to work with a financial advisor who can help you mitigate these issues. Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Paying taxes is a part of earning income and growing your investments. Our tax return calculator estimates your federal tax obligations based on your personal details, sources of income, deductions and exemptions. It forecasts your tax liability and offers the ability to see how adjustments to the inputs affect your taxes.
Photo credit: ©iStock.com/designer491, ©iStock.com/Milan_Jovic, ©iStock.com/designer491