TL;DR
If you pay AMT after exercising ISOs, you will receive an AMT credit that can be used to lower your future tax bills. Read more about how to claim this credit.
The alternative minimum tax (AMT) credit is a reduction given to individuals who have paid alternative minimum tax in previous years. Often times AMT is triggered by exercising Incentive Stock Options (ISOs), thus anyone who has exercised ISOs in years past may be eligible for AMT credits.
How to claim AMT Credit?
This primer addresses how to calculate Alternative Minimum Tax (AMT) credit for Incentive Stock Option (ISO) exercise transactions and then utilize the credit to reduce future tax obligations.
Did you pay AMT?
There are a number of ways to trigger AMT, but this primer will focus on ISO exercise. When calculated AMT, your taxes are calculated in two ways: 1) Standard Tax and 2) Alternative Minimum Tax - if your Alternative Minimum Tax calculation is higher than the Standard Tax version, you will owe AMT. Again, one of the most liekly scenarios where your AMT exceeds your Standard Tax is after and ISO exercise. Read more on how to calculate AMT.
Below is a table on how options are taxed via Alternative Minimum Tax.
Typically, you will know whether or not you paid AMT in a calendar year, however if you are in doubt, you can look back at old tax returns to confirm 1) if you did in fact pay AMT and 2) how much you paid. Once you confirm that you did indeed pay AMT, you can now begin the AMT credit process.
Claiming AMT Credit (Form 8801)
In order to claim your AMT credit, you will need to file IRS form 8801. You typically will not be able to claim 100% of your AMT credit right away due to limitations. Recall that when calculating AMT you calculate your tax in two ways. You are only able to claim AMT Credits based on the difference between your Standard Tax and Alternative Minimum Tax in any given year.
Simple example
Let's say you exercised ISOs in 2020 and your AMT exceeded your Standard Tax by 50,000, meaning you owed $50,000 in AMT in April 2021 (for tax year 2020). If your 2021 Standard tax exceeds your 2021 AMT by $30,000 you will be able to claim $30,000 in AMT Credit for 2021, leaving the remainder for 2022 and on.
Complex Example
As a sample illustration, we’ll follow a typical ISO transaction from exercise through final sale and calculate what happens in 4 different scenarios.
Assumptions
- ISO grant allowing the purchase of 100,000 shares at an exercise price of $1 per share.
- Fair Market Value (FMV) of the shares at the time of the exercise is $6 per share.
- Final Sale of the shares takes place 2 years after exercise so all 4 examples are ISO qualified dispositions triggering LTCG (Holding Period Requirement for Long Term Capital Gains (LTCG) is for the date of the final sale to be at least 2 years from the ISO grant date and at least 1 year from the date of the exercise.)
- This hypothetical tax payer is at the 20% LTCG and 28% AMT rates and has no offsetting income, AMT exemptions/phaseouts, or deductions other than this ISO transaction.
- We disregard the 3.8% net investment income tax to simplify the tax rate at 20% for LTCG.
The valuation spread at the time of exercise is $5 per share (FMV – Exercise Price). This results in $500,000 of AMT Income while regular tax income is $0 because ISO exercises are not subject to regular tax. So in the tax year of the ISO exercise, $140,000 of AMT tax will be due using the AMT rate of 28%. Paying this tax also raises the AMT Tax Cost Basis to $600,000 (100,000 x $6 FMV) whereas the regular tax cost basis remains at the exercise cost of $100,000 (100,000 x $1 Exercise Price). This also results in $140,000 in AMT credit to be utilized in tax year when this tax payer’s regular tax is higher than AMT. In this example, we assume that will take place in the year of the sale.
Conclusions
Many tax professionals describe AMT tax as a timing tax because of the AMT credit offset in future years. As illustrated above, the AMT credit reversal really depends on many contributing factors in the year of sale:
- First, there must be regular capital gains. The AMT reversing adjustment is really a AMT capital gain/loss adjustment because of the tax basis difference between regular and AMT. Without regular capital gain, the reversing AMT basis adjustment will only generate an AMT capital loss carryover, which does not lower the current year AMT liability.
- Second, regular tax must be higher than AMT tax. The bigger the gap, more AMT credit will free up.Timing is everything. To maximize AMT credit offset, we want other realized capital gains. We also want other ordinary income, which helps create a bigger gap between regular and AMT simply because the top rates for regular and AMT are 37% and 28% respectively.
- Lastly, there are many other items (income, deductions, credits, etc) on the returns that may affect the tax calculations, which is beyond the scope of this primer.
This content is for general information purposes only and should not be used as a substitute for consultation with professional advisors such as Leung, Louie, & Co. LLP whom ESO thanks for contributing the information behind this post.
For more information on tax savings, please contact us at the Employee Stock Option Fund.
