How to Avoid AMT on ISOs
If you own Incentive Stock Options (ISOs), you probably already have some knowledge of (and distaste for) the Alternative Minimum Tax (AMT). Paying AMT can be the bane of an ISO holder’s existence because it often catches people by surprise and seems unfair.
The purpose of this article is to provide you with strategies for how to avoid AMT on ISOs.
We’ll begin by discussing what AMT is, why there can be AMT from ISO exercises, then we’ll dive into our 5 tips to avoid paying AMT on ISOs.
Avoid AMT on ISOs by Knowing What AMT is
As we mentioned in the introduction, AMT stands for Alternative Minimum Tax and it’s a tax calculation that gets run simultaneously with the regular tax calculation.
Every year when you complete your taxes, after both the AMT calculation and the regular tax calculation are made, you’ll be on the hook to pay whichever calculation says you owe more!
What Causes AMT on ISOs
The reason you don’t see AMT come up every year at tax time is that there are only certain expenses/events that cause the AMT calculation to result in higher taxes being owed. Exercising ISOs happens to be one of these events.
ISO Spread aka Bargain Element
When you exercise an ISO, you pay the company some dollar amount and, in return, the company gives you a share of the company stock. ISOs are especially great because this transaction often does not cause AMT or any other taxes at exercise.
The AMT problem occurs when people receive ISOs at a really inexpensive exercise/strike price and then the company valuation (and, therefore, share price) goes up drastically.
For example, let’s say that you have 10,000 ISOs with an exercise/strike price of $.05 that are now worth $20 a share. This $19.95 difference is referred to as the “bargain element” or “spread.” And every time you exercise one ISO, $19.95 gets added to the AMT tax calculation.
Here’s a table to help illustrate:
As you can see, exercising a small handful of ISOs probably won’t tip the scale. However, exercising the whole batch of ISOs would cause almost $200k to be added to the AMT calculation and this would likely result in taxes needing to be paid.
AMT Tax Rates
If you have enough income under AMT, you’ll either be taxed at a 26% or 28% tax rate. And if you exercise enough ISOs, much of your bargain element may be taxed at either 26% or 28%.
You might see those tax rates and think, “That’s less than the top federal rates.”
Although that’s true, please keep in mind that the only reason you’re paying these lower rates is because the calculation itself has resulted in you having to pay more taxes. In addition, just because you exercised your ISOs, does not mean that you cashed out money to cover the tax bill!
AMT from ISOs Tax Credit
One difference between AMT and regular taxes is that if you owe AMT, you may receive a credit for the AMT you paid that can be used in future tax years.
Determining the AMT tax credit can get a little tricky because there are some items that result in a refundable tax credit and others that don’t (which is why some tax professionals refer to this difference as Good AMT and Bad AMT).
AMT owed as a result of ISO exercises is considered “Good AMT” and results in a credit that you’ll eventually be able to use to reduce taxes in future years.
This is important to note because, although it’s often recommended to avoid AMT on ISOs, it’s not the end of the world if some AMT has to be paid because eventually it should come back to you.
Why Paying AMT on ISOs Hurts
There are two main reasons paying AMT on ISOs hurts so much and why people try so hard to avoid it.
You’re taxed without receiving a cash benefit.
AMT tax credit can take a while to use up.
The primary reason people try to avoid paying AMT on ISOs is because it’s a tax that’s incurred without receiving an immediate benefit from the ISOs exercised.
For example, if you’re at a private company and exercise ISOs that incur AMT, you’ll need to find a way to pay the resulting taxes and it’s likely that you won’t be able to sell the shares you just received from exercising your ISOs because the company isn’t publicly traded.
It’s a common occurrence for people to exercise ISOs, owe way more AMT than they were expecting, and end up in a major cash crunch when taxes are due.
The second reason paying AMT on ISOs hurts is because even when you receive a tax credit that can be used in future years, if the AMT bill is large enough, it may take several years to use up the entirety of your refundable AMT tax credit.
5 Tips to Avoid Paying AMT on ISOs
Now that we’ve provided some background, let’s dive into our tips for avoiding AMT on ISOs. We’ve written another companion article to this one that discusses when exercising ISOs works well and when it doesn’t.
Avoid AMT on ISOs Tip #1 - Exercise while the company’s value is near the exercise price.
The first tip to avoid paying AMT on ISOs is to exercise somewhat close to the time you received your ISOs.
The reason this works well is because if the company’s current value isn’t much higher than your exercise price, it will likely take a lot more ISO exercises to push you into AMT.
Using the same numbers from the example that we described earlier, let’s say that you have 10,000 ISOs with an exercise price of $.05 only this time the current value (FMV) of the company is $.50. Here’s what that would look like:
As you can see from this example, you’d be able to exercise all 10,000 ISOs and only have $4,500 added to the AMT side of the calculation (which, depending on your situation, is unlikely to push you into AMT).
The risk of exercising when the company has yet to become really valuable is that the company never does anything and the exercise price you pay becomes worthless. In this case, you’d be paying $500, which isn’t a life-changing loss.
Avoid AMT on ISOs Tip #2 - Early exercise and file an 83(b) election.
The next tip to avoid AMT on ISOs can be extremely effective, but it requires two things:
You have the ability to early exercise
You properly file an 83(b) election within 30 days of your exercise
The ability to “Early Exercise” just means that your employer allows you to exercise your ISOs before they have vested.
An 83(b) election is an election made to the IRS which states that you’d like to have your bargain element from ISO exercises taxed at the time of exercise instead of in the future. It’s a paper form that you fill out and physically mail to the IRS and it must be completed and postmarked within 30 days of exercising your ISOs.
If you exercise right after receiving your ISO grant (well before vesting), odds are that the company has not gone up in value during that time. This means that your bargain element will be $0, which means your AMT due to ISOs will also be $0.
Avoid AMT on ISOs Tip #3 - Exercise ISOs over time.
The next method to avoid paying AMT on ISOs is to exercise your ISOs over time.
By exercising smaller batches of ISOs, you can control exactly how much bargain element is added to your AMT calculation every year.
You can get specific with this and determine what’s referred to as the AMT Crossover Point. This is where you figure out exactly how many ISOs can be exercised before you start going into AMT.
By determining the AMT crossover point every year, you can maximize the amount of ISOs you exercise without going into AMT.
A potential downside here is that if the value of the company goes up significantly, it’s possible that you won’t be able to exercise all of your ISOs without going into AMT before they expire.
Avoid AMT on ISOs Tip #4 - Exercise ISOs in high-income years.
The next tip to avoid AMT on ISOs is to complete your ISO exercises in years in which you have a high income.
The reason this works is because as you have more income, you get marginally more AMT budget to cover your bargain element of ISO exercises.
Typically we see people exercising ISOs in the same year they have a large vesting of RSUs, a big bonus, or exercise NSOs. Having more income allows you to exercise more ISOs without having to tilt the scales on AMT.
Avoid AMT on ISOs Tip #5 - Exercise ISOs and sell mature ISOs.
The final tip to avoid AMT on your ISOs is to combine your ISO exercises with the sale of other mature ISOs.
Mature ISOs are ISOs that you’ve already exercised and have held long enough to qualify for a qualifying disposition (which is a sale at least 2 years after grant and at least one year from exercise).
When you sell a mature ISO, there’s often an adjustment to your AMT calculation that frees up additional AMT budget to exercise more ISOs.
This strategy can work well, but it’s best to coordinate with your tax advisor.
How to Avoid AMT on ISOs Conclusion
If you manage to avoid AMT on all of your ISO exercises you can save yourself from some tax headaches and potential cash crunches, but ultimately there are lots of other factors that must be considered (in addition to AMT) as you determine when you should exercise ISOs. In other words, you can’t optimize your ISOs solely by trying to optimize for AMT.
We recommend that you review your unique situation with a financial professional. And, as always, we’re happy to answer any questions you may have.
Thanks for reading. Please feel free to reach out to team@equityftw.com with your comments/questions.