Primer on AMT Credit for ISO Exercises

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.

General Background on AMT

• AMT is a parallel tax system designed to ensure that everyone pays at least some income tax.h
• AMT includes more income items and allows fewer deductions
  - In particular, the increase in value of ISOs are subject to AMT in the year of exercise.
• AMT top rate of 28% is lower than the regular tax top rate of 37%.
  - For Californians, the state AMT rate is 7% compared to the regular tax top rate of 13.3%.
  - For Californians, capital gains are taxed at the same rate as regular income which reduces the benefits of early exercising with your own money.
  - Californians who are not subject to Federal AMT are usually not subject to CA AMT. In general, CA AMT is harder to trigger.
• Taxpayers must calculate taxes both ways and pay the higher of regular tax or AMT.
• AMT credit is generated in the year AMT tax is paid. Maximum credit is the AMT tax paid the year of the ISO exercise. This credit is computed on Form 8801.
• AMT credit may be used to reduce regular tax in future years when regular tax is higher than AMT Credit Reduces Future Tax
• 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.

Taxation for ISO:

Examples

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.
• 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 gain.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.