Learn how Incentive Stock Options are taxed and how to calculate your Alternative Minimum Tax AMT resulting from an ISO exercise.
What is AMT tax?
The Alternative Minimum Tax (AMT) can applies to current and former employees of privately held companies when they exercise their incentive stock options (ISOs). If the fair market value is higher than the strike price the spread between the two values is treated as taxable gain. This can have a significant cash impact on those who exercise their ISOs.
The purpose of AMT is to ensure higher income taxpayers pay their fair share of taxes despite certain preferential deductions that may be available. The three main triggers are having high household income with a significant number of deductions, realizing a large capital gain, or most commonly exercising incentive stock options. Exercising ISOs causes taxation if there is a significant on-paper gain aka (FMV - Strike Price) * Total ISOs Exercised.
How does AMT work?
Alternative Minimum Tax per its name sets a minimum level of taxation that people must pay. To determine if you owe AMT, you must calculate your taxes 2 ways:
- First, the standard income tax method. Just like any year, you are taxed on your income based on your tax bracket and marital status which determine what percentage of your income is owed in taxes. We will call this your Regular Federal Income Tax and this would not include any ISO exercises.
- Second, the AMT method. AMT takes your same income and adds your ISO spread aka (FMV - Strike Price) * Total ISOs Exercised. This sum of incomes is called Alternative Minimum Tax Income or AMTI. It also utilizes an AMT Exemption and either 26% or 28% rate (depending on your income level). This is called your AMT.
Again hence the "minimum" in alternative minimum tax, AMT will take the higher of the two above methods to determine what you owe come tax season. Basically, you pay normal regular federal income tax unless your AMT is higher, in which case you owe the full AMT amount.
The 2023 AMT Exemptions are as follows: $81,300 for single filers and $126,500 for married filers. This is the amount your subtract from your AMTI when calculating AMT.
What these exemptions mean for the year 2023 is that if the spread from your ISO exercise is less than $81,300 for individuals (or $126,500 for married filing jointly), you may not owe any AMT.
The Federal AMT rate is 26% or 28% depending on where your AMT income level falls (26% if below $220,700 or 28% if above). The income calculation includes normal income plus any ISO exercise gain minus the exemption amount. This creates your adjusted gross income (AGI). State rates vary, but most states have none. California for example has a rate of 7%. Other states that have AMT rates are: Iowa (7%),Minnesota (5.8%), and Colorado (3.47%).
AMT Phaseout Thresholds
A less important factor in AMT is the phase out thresholds. The exemptions mentioned above are only available to lower income filers. Anyone above the phaseout threshold lose 25 cents of exemption for every dollar they exceed the threshold level. In 2023, those levels are $578,150 for single filers and $1,156,300 for married filers. For most people, the phaseout threshold does not come into play.
How to Calculate Alternative Minimum Tax (AMT):
The easiest way to calculate AMT is to use ESO Fund's AMT Calculator!
If you want to calculate AMT on your own here is how: First calculate your taxes without the ISO exercise. You can use a tax software program such as Turbo Tax for free as long as you don't file the return. If you use Turbo Tax, there will be a question similar to, "Did you exercise and hold Incentive Stock Options During the Tax Year?" You should answer "No" to this question for now. Now take the following steps:
- Note your total tax amount $ for both state and federal. This is your baseline tax aka Regular Federal Income Tax.
- Now enter an ISO exercise by going back to the question where you initially said No. This time say Yes.
- Enter the number of shares, strike price, and Fair Market Value at the time of the exercise. Normally, you would be entering this information from IRS Form 3921 which your company would have sent you in January of the year following your exercise.
- Upon submitting the ISO exercise event, your total taxes for both Federal and State should immediately update.
- The difference, if any, between this updated tax figure and your baseline taxes noted earlier (1) is the AMT tax associated with your ISO exercise.
To calculate how many ISOs you can exercise each year without triggering AMT tax, enter a smaller number of shares in (3) and gradually increase it until your tax due actually increases over the baseline calculation.
Note that tax rates can change between the time you do this exercise and the time you actually file your return. Moreover, many other factors such as deductions, your tax bracket, state income taxes, and capital gains will also impact your final AMT tax calculation. Since the ESO Fund has no way of knowing how your final taxes will look, you are advised to work with a tax professional to minimize your risk of not having sufficient funds when you finally file your tax return. The ESO Fund is not obligated to increase its funding to you at a later date.
If you exercise and sell ISOs in the same tax year, this is called a Disqualifying Disposition. In this case you no longer owe any AMT on the ISOs sold, but only pay income tax on the sale sale process minus your cost to exercise. This eliminates any double taxation for sales that occur in the same calendar year as the option exercise.
AMT Credits and Double Taxation
But what if you hold the shares longer than 1 year and sell them, are you double taxed?
The answer is no, but with a catch. It is true that when you finally sell shares that were formerly ISOs, you pay either Income Tax or Long-Term Capital Gains on the difference between the sale price and your strike price. Since you have already paid AMT on the difference between your strike price and the FMV at exercise, you are technically being taxed twice on that portion of the income. The way to recoup this double taxation is through the AMT Credit process.
Simply put, you can recoup a certain amount of AMT each tax year, assuming you don't owe additional AMT for that year. See the link above for more on the AMT Credit process.
Letting ESO Fund the Exercise and Taxes
Since the cost of exercising stock options is already very high, the addition of taxes makes the entire investment even more risky. A solution for reducing this risk is obtaining funding from the ESO Fund to cover theentire cost of exercising your stock options, including the tax. You retain unlimited upside potential without risking any of your personal capital. If you exercised your ISO stock options earlier this year and are concerned with the tax burden next year, then ESO is an ideal solution since we can provide money for the AMT and even reimburse your exercise costs..
You retain title to the stock in an ESO transaction. Since you don't have to transfer the stock or pledge it as collateral, this greatly simplifies the paperwork needed to obtain funding from ESO. You also retain the ability to payoff ESO at any time before the company exits. For more information on reducing stock option taxes or regarding how ESO can benefit you, please contact us below.