Incentive stock options and the AMT
If you receive incentive stock options (ISOs) from your company, there are a number of things to consider:
How are ISOs taxed?
People often are told that ISOs, also known as qualified stock options, are more remunerative than nonqualified stock options (NQSOs) because they are not subject to ordinary income and payroll tax on exercise, whereas NQSOs are. In addition, if you hold the resulting ISO stock for more than a year, you can sell the stock and ultimately pay only long-term capital gains tax rates on the difference between your strike price and your sale price. (If you are unfamiliar with the basics of stock options, please see our Wealth Focus on Managing Stock-Based Compensation in Private Companies.)
While it is true that ISOs are not subject to ordinary income tax on exercise, the spread between the strike price and fair market value of the stock at exercise is subject to the alternative minimum tax (AMT) on exercise. Depending on your situation, if you pay the AMT when you exercise an ISO, you may not get the full benefit of the long-term capital gains treatment. In fact, because of the way the AMT works, you may end up paying a higher rate by holding the stock than you would pay by exercising the option and selling the stock the same day (a “disqualifying disposition,” which subjects the spread to immediate short-term capital gains tax and eliminates any AMT liability that was incurred).1
How the AMT can disrupt the best-laid plans
Each year, you calculate your income tax in two ways. (This is largely simplified and for illustrative purposes only, but it’s sufficient to explain why ISOs sometimes do not work to your advantage.):
The first way is the one with which you’re likely familiar: You start with your income (e.g., employment, investment, rental, etc.), subtract deductions, and apply the graduated tax rate to the resulting amount. This gives you your ordinary income tax amount.
For AMT purposes, you start with your income. You are only entitled to very few deductions, and you must add back “preference items” that would not be included as income under the first method. One such preference item is the spread on ISOs you’ve exercised during the year. Once you apply the AMT rates to this total amount, you come up with a dollar amount of tax—your “tentative minimum tax.”
To determine your AMT liability, if any, you must compare your ordinary income tax with your tentative minimum tax.
Let’s say your ordinary income tax amount is $300,000. If your tentative minimum tax is higher than your ordinary income tax—say, $340,000—you’ll pay ordinary tax of $300,000 plus alternative minimum tax of $40,000.
If your tentative minimum tax is lower—say, $280,000—you’ll pay ordinary income tax of $300,000 and no AMT.
If your AMT is higher than your ordinary income tax as the result of ISO exercise, you get a credit (in the example above, $40,000) that you can use in a future year to reduce your tax bill.
However, you can only use your credit in a year when your tentative minimum tax is lower than your ordinary tax. So if in the year after exercise your ordinary tax is again $300,000 and your tentative minimum tax is $340,000, you can’t use your credit that year, although you may get another $40,000 credit. Your unused credit carries forward indefinitely; but if, in the meantime, you sell the stock more than a year after exercise, you will pay long-term capital gains tax on the spread between the sale price and the exercise price. So you might have paid both AMT (on exercise) and long-term capital gains tax (on sale) on at least a portion of the spread.
If, in the example, in the subsequent year your ordinary taxable income is again $300,000 but your tentative minimum tax is instead $280,000, you can use $20,000 of your credit to reduce your tax to the lower amount of $280,000—but not below that amount. Again, if you aren’t able to fully use your credit in the year you sell your stock, the credit carries forward but becomes less and less valuable in each subsequent year (due to the time value of money).
Exercise your ISOs early in the year
If you exercise ISOs and the stock price increases throughout the year, then it may be worthwhile to hold the stock in order to take advantage of the long-term capital gains rate (i.e., hold the stock for at least a year and a day after exercise and two years after grant). If instead the stock price decreases, then it may be more economical to sell the stock and pay short-term capital gains tax on the spread as of the date of sale.
So, if you plan to exercise your ISOs, it is better to do so early in the calendar year so that you can maximize the time you have to track the stock’s price movement throughout the year and decide whether or not to sell in a disqualifying disposition before the end of the year.
Talk to your accountant
The AMT is very complicated—far more so than described here. Your J.P. Morgan Advisor can work with you and your accountant and other tax advisors to analyze all of your stock-based holdings in your company and craft a thoughtful exercise and divestment plan that helps you pursue your goals.