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Book with AMT rules

If incentive stock options (ISOs) are part of your compensation package, knowing what they are, what they can do for you and how their tax treatment is going to affect you in the future is important. At the very least, you have to determine how they will affect your federal income taxes when you exercise them. Otherwise, you could be in for a really serious surprise come tax time due to a possible trigger of the alternative minimum tax (AMT) when you exercise the ISOs.

Consider working with a financial advisor to ensure you don’t overpay on your investment taxes.

What Is an ISO?

An ISO, or incentive stock option, is an employee benefit that gives employees the right to buy shares in their employer at a discounted price and later enjoy possible tax advantages. ISOs are typically offered to top management and key employees as part of a compensation package designed to retain them. If managed correctly, they may also be referred to as qualified stock options, since they often offer preferential federal tax treatment. When they are sold, the sale is usually a qualifying disposition.

ISOs are only one type of stock option offered as part of a company’s stock purchase plan. NSOs, or non-qualified stock options, are often offered to all employees in the organization. They do not offer preferential tax treatment.

How an ISO Works

When employees hold incentive stock options, they can purchase a set number of shares of stock at a pre-determined price on a future date regardless of the market price, but only after the vesting period. The options are issued to employees on the grant date. On the exercise date, the employee can exercise their right to buy the options as long as it is after the vesting period. The ISO requirement is a minimum vesting period of two years with a holding period of at least one year.

The ISO can then be exercised at the strike price, which is the price at which it was issued. This creates the bargain element since the option was sold at a lower, discounted price (the bargain price), which may be lower than the market price of the stock. The difference between the strike price or bargain price and the market price, if it is higher, creates an immediate gain for the employee with no tax owed at that time.

If the market price is lower than the strike price, then the employee should not trade the stock until it moves higher. That has to be done within 10 years, the usual expiration date for ISOs. If the employee sells ISO stock after the incentive stock option is exercised but before the end of the one-year holding period, there is no favorable tax treatment.

Understanding the AMT

The AMT is a method of calculating the tax liability of wealthy individuals and corporations that aims to ensure wealthy taxpayers will pay at least a minimum amount of federal income tax. The AMT takes away certain deductions and tax credits and effectively places a lower limit on the amount of federal income tax an employee or corporation pays each year. In essence, it’s a tax system that’s parallel to our normal income tax system, and it’s aimed to catch types of income individuals receive in less standard ways.

The AMT requires taxpayers exercising an ISO to report the profit difference between the bargain price paid for a stock and the market price when it’s sold. If you hold an ISO until a year after the exercise date and two years after the grant date, your tax on the spread between the strike price and the market price will be taxed at the lower long-term capital gains tax rate. In this case, you may be subject to the AMT.

If you don’t hold the ISO for one year, you pay ordinary income tax on any gain, but you will not be subject to the AMT, which is one of the tax advantages of ISOs. However, in this case, you may sacrifice any long-term price appreciation of the stock.

Tax Consequences of Selling ISOs

Man calcualting his federal income tax

Once you reach a certain income level, you have to calculate your AMT along with your federal income tax returns. The income level is the amount exempt from the AMT. In 2021, if you are single, your income exemption amount is $73,600. If you are married filing jointly, it is $114,600 and if you are married filing separately, it is $56,300. In 2022, if you are single, your income exemption amount is $75,900. If you are married filing jointly, it is $118,100, and if you are married filing separately it’s $56,300. In addition, business expenditures as deductions are less and so are itemized deductions for individuals. Property taxes paid to state and local governments are not allowed and neither are medical expenses.

There are five possible scenarios for tax purposes concerning whether or not you are subject to the AMT:

  1. You purchase and sell your ISO stock in the same year.
  2. You purchase and sell your ISO stock in 12 months but not in the same calendar year.
  3. You purchase and sell your ISO stock in at least one year after the exercise date but less than two years after the grant date.
  4. You purchase and sell your ISO stock at least one year after the exercise date and at least two years after the grant date.
  5. Your purchase and hold on to your ISO stock indefinitely.

Scenarios 1, 2 and 3 are disqualifying dispositions and receive no preferential tax treatment. Scenario 1 does allow you to avoid the AMT altogether. Scenarios 4 and 5 are qualifying dispositions and the bargain element for the exercise of all options during the specified time frame will be applied to the AMT.

If you trigger the AMT on your federal tax return due to an ISO exercise, it is seen by the Internal Revenue Service (IRS) as a prepayment of taxes that you will recover in the future. You will receive a future minimum tax credit (MTC). Your MTC needs to be calculated every year until the credit is zero to keep track of it and as you have more ISO exercises, you have additional MTC.

Since most people don’t like the idea of prepaying taxes, they try to avoid the AMT. Since the MTC and AMT are complicated issues, the only safe way to determine if you would be better off with the AMT is to consult a tax professional or other financial professional skilled in both the AMT and ISOs. You can then determine how many ISO exercises you can perform in one year without triggering the AMT along with associated issues. You may be advised to trigger the AMT, given the analysis of your personal situation, to receive long-term capital gains treatment.

Bottom Line

Paper money and "STOCKS" written on top

The AMT applies to taxpayers with high economic income – including possibly those who exercise their ISOs – by setting a limit on those benefits. It helps to ensure that those taxpayers pay at least a minimum amount of tax. There is no one answer to the question of whether or not you’d be better off triggering the AMT with ISO exercises unless you perform a complete analysis of your financial situation or, better yet, have the analysis done by a tax professional or financial advisor.

Tips on Investing

  • Give yourself every advantage as you plan a tax strategy and prepare your returns by working with a financial advisor. Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three 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.
  • Do you want to do some preliminary calculations for income tax purposes on your capital gains for this year? Check out SmartAsset’s capital gains calculator which can help you.
  • If you need a better understanding of income tax, take a look at SmartAsset’s income tax calculator and the information it offers.

Photo credit: ©iStock.com/designer491, ©iStock.com/gorodenkoff, ©iStock.com/MCCAIG

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