AMT and the AMT Tax Credit

AMT (“Alternative Minimum Tax”) is one area of the tax code that a start-up employee knows a lot more about than your average taxpayer, since incentive stock options are a common AMT trigger. Though many know about AMT, or at least have heard of it, few truly understand its mechanics due to the many moving parts in the analysis. We will address AMT calculations and credits, and explain why AMT isn’t as bad as it is commonly made out to be.

For every Federal income tax return you file, two calculations are performed: one for the “regular” tax, and one for the AMT. The higher of those two numbers becomes your tax bill for the year. The AMT calculation is usually done in the background, and is rarely ever noticed.

Most people are not “subject to AMT”, since their regular tax exceeds the AMT one.

When your AMT is greater than your regular tax, that excess appears as a separate AMT tax due. You are now “subject to AMT”.

How is AMT presented?

As an example, let’s say that your regular calculation shows a tax bill of $5,000. As long as the AMT calculation is less than $5,000, you will not see AMT anywhere on your tax return.

Now imagine that your AMT is calculated at $6,000, while regular tax is still at $5,000. Total tax liability will be presented as follows: $5,000 of regular tax and $1,000 of additional AMT.

When will I be subject to AMT?

AMT is different compared to regular tax in a few ways. The tax rates in AMT calculations are different - AMT is almost a flat tax starting at 26%, compared to the many tax brackets used in their regular tax calculations. The primary difference though is in the definition of income and deductions for AMT purposes.

While one item may give you a regular tax deduction, it might not be a deduction for the AMT calculation. Property taxes are one example of this - they can be a regular tax deduction but will not reduce your taxable income for AMT purposes.

The most common income category that triggers AMT is related to ISOs, or Incentive Stock Options. The discount between the Fair Market Value of the stock received by exercising an option and the exercise or strike price becomes income that is included in calculation of AMT. This phantom income (also known as “the spread”) is not subject to regular tax but is subject to AMT.

What about the AMT credit?

You can think of AMT as a prepayment of sorts. When you pay AMT, that amount gets accumulated into an “AMT Credit” (aka “Minimum Tax Credit”), which gets rolled forward into subsequent tax years. If the AMT calculation in one year falls below your regular tax calculation and you have an AMT Credit carryforward, the difference between the AMT and regular tax numbers will be given back to you as a reduction of tax due for that year. This goes on until you recapture all the AMT previously paid (“use up the credit”).

As an example, let’s say that you have a $5,000 regular tax liability for the year. Since you exercised some ISOs during that year, your income for the calculation of AMT is higher, and your AMT total is $6,000. You pay $5,000 of regular tax and $1,000 of AMT for a total of $6,000. You now have $1,000 of AMT credit available for future tax years. The following year your regular tax liability is again $5,000, but the AMT calculation is only $4,300. Your total tax liability ends up at $4,300: the $5,000 of regular tax less $700 of AMT credit. The remaining $300 of AMT credit can be used in future years.

Most often the large AMT credits are utilized during the year when you sell AMT-laced shares, since those shares will have higher cost basis for AMT purposes (assuming the shares have appreciated in value). This larger income adjustment will likely cause AMT to be lower than your regular tax, using up a large chunk of AMT credit carryforward. It is particularly important to correctly file your tax returns for the years when you sell shares acquired through ISO exercises.

As another example, let’s say someone pays $100,000 in AMT one year due to a significant ISO exercise. They could get back smaller amounts every year as AMT credits, and then receive the entire remaining balance years later when they sell the shares, at a gain, that initially caused the AMT bill in the first place. Since this would be reported as a “Qualifying Disposition” on the tax return for the year of the sale, AMT income will be reduced for the amount of “spread” in the sold shares, resulting in AMT being drastically smaller than the regular tax amount for the year. That difference should free up the remaining AMT credit.

Things to watch our for:

If the share value has dramatically dropped from the date of exercise, this could jeopardize the speed at which you’re able to recover your AMT Credits. Similar to limitations around capital losses, there are limitations around AMT-related capital losses.

Additionally, if you sell those shares before holding them for more than one year (or less than two years after the grant date), it will be taxed as a Disqualifying Disposition, hindering your ability to recoup a large chunk of the AMT Credit in that year.

How can I avoid AMT?

Most likely, you have some “AMT room”: the amount of AMT-causing income you can absorb before AMT is triggered. The room is calculated based on the expected regular taxable income for the year. Exercising ISOs within that discount room is one strategy of AMT avoidance. If your taxable income increases (e.g. from a disqualified disposition of an ISO), your AMT room might increase, allowing for additional exercises under the AMT trigger point. Your tax or financial professional should be able to provide you with your “AMT room” number and run additional scenarios.

When you exercise an ISO and sell that stock in the same calendar year, there is no AMT adjustment for the exercise. Exercising earlier in the year gives you extra time to plan for potential disposition of those shares.

Other considerations:

An important consideration in planning for AMT is state taxes. While some states don’t have their own version of AMT calculations, other states do (e.g. California). We have certainly seen surprises in cases where people were not expecting their state to present a tax bill for an ISO exercise.

We hope that you found this helpful, and that your understanding of AMT has improved. If you have any additional questions around ISOs or AMT, feel free to poke around the blog, send us an email, or schedule a time to chat.