Understanding How The Alternative Minimum Tax Affects Your Incentive Stock Option Exercise Decisions
“Like mothers, taxes are often misunderstood, but seldom forgotten.”
–Lord Bramwell, 19th Century English jurist
Perhaps you’re reading this as an early employee of a company such as AirBnb, Palantir, or Postmates which have considered an initial public offering or direct listing. This leaves you weighing whether or not to exercise some or all of your incentive stock options (ISOs). But you’ve heard that the alternative minimum tax could hit you with a large tax bill even before you have the ability to sell any of your shares. This is true. But this does not mean you should not consider exercising some or all of your options. Let’s talk about why.
If you’ve been scouring the internet trying to wrap your head around the concept of the alternative minimum tax (AMT) and how it applies to your startup’s equity compensation you’ve probably come across at least one financial advisor, tax professional or journalist that has tried to scare you into believing that the AMT is a confusing mystery , far beyond the common woman or man.
I’m here to say that’s bogus. I submit that with the Tax Cuts and Jobs Act in place, AMT likely shouldn’t worry you. Why? Because it is likely that either you won’t owe AMT when you exercise your incentive stock options, or, you will owe AMT but the utilization of the AMT tax credit over subsequent years will lower your effective taxes in subsequent years commensurately.
Depending on how much time you’ve spent reading through what’s available on the internet, odds are good that you understand the basics. Maybe you just read our primer on Incentive Stock Options. You may understand that the Alternative Minimum Tax is a secondary method of calculating your tax liability that considers, among other things, the difference between the fair market value of your options and the exercise price you pay to purchase the underlying company stock. You may understand that if you purchase your options and then hold onto the stock at least two years from when your options were granted and one year from when you exercised them you will be subject to long-term capital gains rates rather than ordinary income rates on this difference in value when you sell. You also know that those of us in San Francisco and the Bay Area remain subject to the California long-term capital gains rates that mirror ordinary income rates.
But you may also be misled into thinking that you will be taxed twice on these options with both AMT and a subsequent regular tax burden. If so, you may then be tempted to try to avoid the AMT and by doing so miss out on maximizing the value of your company stock by mistiming equity decisions. Much to the possible chagrin of some my fellow tax nerds, I’ll simplify your path forward with four steps to cracking the AMT.
Cracking the AMT, as easy as 1, 2, 3 (4).
1) Use the tax calendar and split your exercise over two (or more) years. The easiest way to avoid the AMT is to stay below the AMT threshold. To provide you with an order of magnitude, a single software engineer making $150,000 could exercise options with a bargain element of approximately $25,000 without hitting the AMT. For example, if you have 5,000 options with an exercise price of $2.00 each (total price $10,000), and a fair market value (FMV) of $7.00 each (total FMV of ISOs being $35,000) you could exercise all your options without becoming subject to the AMT.
But what if you have twice as many options? Or are you thinking about leaving your job and want to avoid AMT? One way of hacking this scenario is to exercise in tranches, that is, in several steps, over the course of the end of one calendar year and into another. You could utilize the bargain element of $25,000 in December of 2020 and another $25,000 in January of 2021. Doing so, would allow you to exercise $50,000 of bargain element within the span of just a few calendar days but two tax years.This strategy might have useful implications if you are considering leaving your job or your start-up is rumored to be preparing for an IPO.
2) Utilize the AMT tax credit in subsequent years. If you’re fortunate enough to have more of a bargain element than what would ever allow you to avoid AMT the news is still good. While you will pay the alternative minimum tax in one year this will generate an AMT tax credit which will be tracked on your tax returns. In future tax years, your overall tax will be reduced by this credit. What is often missed by those hawking the dangers of AMT is the reality that AMT will likely not cause you to pay more in taxes than you would under ordinary rates over the long-term. Rather, the AMT serves to front-load your tax in the year you exercise a large number of options, and then lower your taxes in future years.
However, this does necessitate that you set aside appropriate cash to cover your AMT tax bill and possibly pay quarterly estimated taxes.
3) Track the dual basis of your exercised incentive stock options. Exercised incentive stock options carry two cost-basis values. The first basis simply tracks how much you paid for your shares upon exercise, while the other includes the AMT preference amount as a secondary basis. Both the basis under the AMT and the ordinary tax rates must be tracked moving forward to properly account for their growth (or loss) when you ultimately sell your exercised shares. I’ve seen tax return errors in this regard cause a taxpayer to overpay their tax by almost $100,000. Put simply, that’s a return that you’d want to amend.
4) Have a professional file your taxes and review major options exercises prior to moving forward. As firmly as I believe you should understand AMT theory, I just as heartily believe that the mistakes you might make by Turbotaxing your returns in the years you exercise options or sell stock just aren’t worth it. Avoid the headache, and get it right the first time. If you need help, I’m happy to run projections that help you maximize the value of your options, and to refer you to tax preparers that are well versed in incentive stock options and the alternative minimum tax.
So, there you have it. These four principles offer guideposts for you to consider as you navigate the exercise of your stock options. Whether your employer undergoes an IPO or an acquisition in the next year, or in 10 years, having a working understanding of how the AMT affects your tax situation and exercise choices is critical to maximizing your return and weighing the potential pitfalls inherent in owning private shares.
Finding the right time to exercise your options in order to take advantage of long-term capital gains rates on their growth, maximize your return on capital (which you can read about here), and avoid tax surprises becomes a little bit of balancing act. You needn’t navigate this alone. Let us join you in managing your personal situation as you coordinate your financial picture.