Incentive stock options, ISOs, can be a great benefit from an employer. However, many people don't talk about or understand the ISO tax treatment, including AMT.
Before exercising your ISOs, ensure you know how to avoid AMT on stock options to make the most of the benefit that's supposed to increase your income.
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What Is AMT?
AMT or alternative minimum tax is a tax you may owe if you exercise your ISOs. When you prepare your taxes, your tax software program (or tax preparer) calculates your regular tax bill and your AMT liability. You'll owe whichever is higher.
You pay AMT when your income exceeds the exemption amount for the year. For example, in 2023, the exemption amount is $81,300 for single filers and $118,100 for married couples filing jointly.
The government created the tax to ensure that people with higher incomes pay their fair share of income tax. However, AMT doesn't allow most deductions like regular tax and has only two brackets, 26% and 28%.
What Are Incentive Stock Options?
Incentive stock options, or ISOs, are a benefit from an employer that allows you to buy shares of the company stock at a discounted stock price. There may also be some tax breaks on capital gains, but understanding the taxation of stock options is important.
Ins and Outs of Incentive Stock Options
How Are Stock Options Taxed
ISO taxes can be at the long-term capital gains rate if you hold the stocks for at least one year after exercising incentive stock options, and it's been at least two years since the grant date. Depending on your regular income tax rate, you could save as much as 20% on the capital gains tax.
Key ISO Stock Terms to Remember
There is a catch, though. If you receive incentive stock options, your earnings could trigger AMT, and understanding these terms will help you determine it.
- Bargain element - The difference between the stock's fair market value and grant price is the bargain element. You'll calculate this number if you exercise incentive stock options but don't sell the stock.
- Grant price - This is the price you'll pay for your incentive stock options.
Key Benefits of ISO Options
The largest benefit of an ISO option is the tax savings. You don't pay taxes on stock options when you exercise your option to buy shares, and there may be tax benefits if you hold the shares for at least one year and two years from the grant date.
Holding the shares for at least one year allows you to pay long-term capital gains taxes versus regular taxes, saving a significant amount of money depending on your taxable income.
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How Does AMT Affect Stock?
When you receive an ISO stock option as a part of your benefits package, you don't have to claim them as income yet. However, exercising incentive stock options can trigger taxes on incentive stock options, including an AMT liability.
The key is to have qualifying dispositions, meaning you pay only long-term capital gains tax on the earnings. The only way to do this is to buy and hold the shares for at least one year after exercising incentive stock options and two years from the grant date or holding the stocks long-term.
If you have disqualifying disposition, you may trigger an AMT liability. Here's how that might occur:
- Buy shares and sell them the next calendar year, but in less than twelve months
- Buy shares and sell them more than one year later but within two years of the grant date
The bargain element may create an AMT liability if you have a disqualifying disposition. Remember, the bargain element is the difference between the fair market value and the grant price. This amount can put some people over the AMT threshold, triggering a higher tax liability.
Please note if you buy shares and sell them in the same calendar year, you won't trigger an AMT liability, but you'll pay your ordinary tax rates on the income.
Avoiding AMT on ISO Stock Options
The easiest way to avoid AMT on ISO stock options is to exercise your shares early in the year, typically in January.
This gives you the entire year to decide what to do. As you near year's end, determine your tax liabilities and if selling the shares in the same calendar year makes sense. It will trigger a disqualifying disposition, but you'll pay your ordinary income tax rates on the earnings and won't trigger AMT.
You can also use this method to sell only the shares needed to avoid triggering AMT since most people have a good idea of their tax situation by the end of the year.
Exercise and Hold
If you exercise and hold, you won't trigger AMT until you sell the stock. However, you can get strategic with this method and only sell the shares that won't trigger AMT. For example, if you have some years where your income is higher than others, don't sell the stock during those years to avoid triggering AMT, and vice versa.
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Avoid AMT After a Company Publicizes
If your company has a successful IPO, it puts you in a different situation. First, keeping all your capital tied up in your company's stock is risky. You should always have a diversified portfolio, so holding onto the stock for too long can be risky.
Like before the IPO, it's best to hold onto the exercised shares for at least one year to avoid the ordinary income tax rate.
However, there's a loophole. You can exercise your shares and sell them the same day, but you'll lose the long-term capital gains tax rate, which only works if you aren't already in a high tax bracket.
The final option is to exercise your shares slowly after the IPO. However, you must stay at the company the entire time or lose your stock options.
Additional Ways to Limit AMT
Exercising financing to cover the cost of exercising the shares, including your tax liabilities. You keep the shares but can exercise your options before your AMT liability increases. You'll use a portion of the capital gains when you sell the shares to pay the loan's fees, but in many cases, the fees are less than the cost of the potential AMT burden.
The 409A Valuation
The 409A valuation is the stock's fair market value. As this value increases, so does your risk of triggering AMT. Each time the 409A valuation increases, your bargain element increases, as does your tax liability.
To avoid higher tax liabilities, you can strategically plan the percentage of your ISOs to exercise each year to stay below the threshold based on the current fair market value.
A handful of websites offer a secondary market to purchase your ISOs. Then, when you sell your options, you have the fund to cover the cost of exercising your remaining options.
However, you take the risk of the stock price increasing, leaving you without the gains you could have earned if you kept the ISOs.
Limitations to Exercising ISO and AMT
When a company issues ISOs, you must stay at the company as long as it takes to exercise your options. For example, if you use a method to limit your AMT, you may have to stay at the company for ten years or more, depending on your strategy, or you will lose the benefit.
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What Are AMT Credits and How Do They Work?
The alternative minimum tax credit is a dollar-for-dollar credit you may be eligible to use in the years you don't trigger the AMT tax. So if you pay AMT tax for a few years and don't trigger it the following year, you can take the AMT credit for the surplus paid in previous years.
When Did AMT Originate?
AMT originated in 1968, right after the Vietnam war, to ensure that households with high incomes paid their portion of taxes.
How Do You Determine the Type of Stock You Own?
Before buying stock, always ask the type, whether it's a growth, value, or dividend stock. The type of stock you own will affect how you receive proceeds and your taxes on the stock.
Is AMT Necessary to Pay?
If you exceed the AMT exemptions, AMT is necessary to pay; however, there are ways to avoid it, such as timing when you exercise your options.
ISOs are a great benefit from companies, but you must know how to use them correctly. They are more than your ordinary taxable income and can negatively affect your tax liability if you aren't careful. Knowing how to avoid AMT on stock options by buying and selling them at the right intervals can help you avoid alternative minimum tax and increase your tax liability.