How to Avoid AMT
What is AMT? Is AMT applicable to me? How can I avoid AMT? Read on to find out!
The misunderstanding of AMT has caused thousands of employees to bolster hefty tax bills. Lucky for you, it might not be too late to prepare for and avoid AMT.
My friends, welcome! It’s Riley Hale here, financial planner specializing in equity compensation. In this article, I’m going to be covering what AMT is and how to avoid it when exercising your incentive stock options (ISOs).
Understanding why AMT was created will help you understand how to avoid it. So let’s get started.
Where Did AMT Come From?
AMT is an acronym for Alternative Minimum Tax. It was created by congress in 1986 to curb any abuse of the income tax system. At the time, the wealthy were implementing tax planning strategies that allowed them to completely avoid paying income tax. The alternative minimum tax was a way to get the wealthy to pay taxes and increase the tax revenue, ensuring a funded government. It required every taxpayer to pay their “fair share” of taxes by creating a floor on minimum taxes. This is why AMT was created.
Next, let’s take a high-level look at the technical side of the alternative minimum tax.
How AMT Works
AMT is a tax calculation that all taxpayers have to calculate. In addition to your regular tax liability calculated on form 1040, the parallel AMT tentative tax is calculated on form 6251. As a taxpayer, you are required to pay the higher of the two—regular income tax liability or tentative AMT. Only a few people become subject to AMT because their regular income tax liability is lower than their AMT tentative tax. So by decreasing your income tax liability, it’s more likely you’ll have to pay AMT. Do you see how this catches the tax planners who used to avoid paying taxes?
Although intended for the wealthy, on occasion, the tax overreaches and middle-income individuals become subject to AMT. Unfortunately, this is common for those exercising their incentive stock options.
Due to the complexities and unaffordable tax bills created by incentive stock options, Restricted Stock Units (RSUs) have become increasingly popular. Consider yourself lucky if you have RSUs or Nonqualified Stock Options (NSOs), because AMT does not apply to these. You become subject to AMT only when you exercise ISOs.
How much does AMT increase by exercising? Your AMT is the spread between the grant price (stated on your grant document) and the fair market value of the shares on the date of exercise. This spread is known as the bargain element. So if you own many incentive stock options and you start exercising them, your bargain element could exceed your regular income tax, subjecting you to AMT.
The problem is, when you exercise your incentive stock options, it increases your AMT... increasing the chance that your AMT is raised higher than your regular tax liability. And because exercising options usually amounts to large sums of money, people’s AMT can skyrocket. This wouldn’t be a problem, except you can’t always sell your newly-exercised shares to pay the AMT tax burden. So if you don’t have the cash to pay for it, then you’re in trouble. For example, there are many stories where individuals exercise a massive amount of stock options and then get an AMT tax bill that is much larger than their net worth. They could pay for it if they could sell their incentive stock options, but one can’t always choose when to sell with private companies. You generally have to wait for something like a tender offer in order to sell. Unsuspecting people, unaware of AMT, generally have to surrender their stock options in these circumstances...all because they couldn’t pay the tax.
So what can you do? There are ways to avoid getting into this unfortunate situation by implementing the strategies below in advance of exercising your incentive stock options.
How to Avoid AMT
First, let me start with a word of caution: implementing the strategies described below requires professional help. Please don’t try this without the help of your financial professional.
Okay, now on to the strategies. Let’s compare AMT to a window. If you go through it, you have to pay. If you don’t go through it, you don’t have to pay. As a financial planner, it’s my job to manipulate one’s finances to avoid going through the AMT window. There are three main ways to do this:
Overshooting AMT
Undershooting AMT
Going Around AMT
Overshooting AMT
The concept here is increasing your income tax liability so that it falls above your AMT liability.
Income shifting
This is where you shift income into the year you’re trying to avoid paying AMT. Remember, you pay the higher of your regular tax liability or your tentative AMT liability. So if you want to avoid AMT, just increase your regular tax liability. This is only applicable if you’re able to shift your income through things like capital gains, commissions, or bonuses where you have the choice of when to receive it. So if you’re closing a deal that gives you a huge increase in income, then you might consider shifting that to the year you’re exercising your ISOs and trying to avoid AMT. This makes financial sense only if your income tax rate is lower than the AMT tax rate which can be either 26% or 28% based on your tax bracket. For example, if you’re in the 22% tax bracket, it makes sense to pay 22% rather than AMT’s 26%.
Deduction clustering
Rather than taking deductions that decrease your regular income tax liability, you delay and cluster them together for a later year when you’re not exercising incentive stock options—effectively keeping your income high for the year that you are exercising ISOs. It’s best to save those deductions for the year where you’re selling those ISOs (also known as the year of disposition). These delayed deductions can then reduce the amount of income you’ll have to pay taxes on during the year of disposition. So you get to save on taxes for two distinct years: the first when you delay deductions and avoid AMT on exercised shares and the second when you take those delayed deductions and avoid high income taxes on sold shares.
Undershooting AMT
This is essentially the same concept as overshooting AMT, but undershooting deals specifically with decreasing your AMT below your regular income tax liability (whereas overshooting was about increasing your income tax liability).
Exercising sooner than later
Timing can play a huge role in avoiding AMT. Remember, the AMT you pay upon exercise is the bargain element (the spread between grant price and the fair market value). When a company is young, it typically has a low valuation meaning the bargain element is likely very small. That tiny bargain element might not trigger AMT, but in the case it does trigger AMT, it’ll be much smaller. If you wait, the company’s valuation is likely to go up, meaning a larger bargain element and therefore a higher AMT.
AMT crossover
This is where you exercise at the end of the year, knowing exactly how much you can exercise without triggering AMT. At the end of the tax year, you’ll have a pretty accurate picture as to what your taxes will look like. You can take advantage of this to exercise just enough to not trigger AMT. This works great for exercising over several years (such as when the shares vest), rather than in one large, lump sum exercise. This will take some serious planning to get it right, so here’s my friendly reminder to work with your financial professional.
Early exercise
An “early exercise” is where an employee exercises their incentive stock options before the options vest. Not all companies offer this, so this may or may not be applicable to you. Ask your employer or check your grant document to see if this is a possibility. If you can and choose to do an early exercise, you should consider making an 83(b) election. This is where you freeze the bargain element for AMT purposes. Note that an 83(b) election must be filed within 30 days of exercise, so get on it quickly if applicable. While section 83(b) doesn’t usually apply to ISOs, this is the rare case where it does, but it only works for exercising unvested stock. Early exercising generally makes sense if you’re one of the first few employees at a company that’s less than a year old.
As a side note, if you truly are one of the first few employees of a tech startup, you should look into the tax benefits of qualified small business stock (QSBS) which I discuss in another article. Here’s an opportunity to be a hero and share this article with your company’s founders so they can get help with their AMT too.
Going Around AMT
The concept of going around AMT is finding ways to eliminate AMT without manipulating AMT or your income tax liability.
Disqualifying disposition
This is where you sell in the same calendar year of exercise. When you sell within a year of exercise, your ISO essentially becomes an NSO (through disqualifying disposition). And because AMT only applies to ISOs and not NSOs, you just side-stepped any AMT from exercising your options. You’ll need to weigh the benefit of this one carefully. While doing this can avoid AMT, NSOs also lose the tax benefits of ISOs.
This strategy works best for employees of public companies who exercise at the beginning of the year. Why? Exercising at the beginning of the year leaves you with the rest of the year to see if you need to sell shares or not to avoid AMT. It’s best to do this if you’re at a public company because public companies have liquidity—meaning you can sell your exercised shares quickly and easily if you need to. Private company shares aren’t so liquid...you typically need a liquidity event (such as a tender offer) in order to sell shares. If that opportunity to sell doesn’t come, then this strategy would fail and you’d have to pay AMT. So that’s why it’s only recommended for employees of public companies who exercise at the beginning of the year.
This has to be a calculated risk because if done wrong it could mean owing more taxes. So you should work with your tax accountant or financial planner to hone in on this strategy.
If You Have to Pay AMT...
If there is no way around AMT and you have to pay it, that stinks. But there’s another planning opportunity my friends!
Here’s a way to save on your AMT taxes if you’re in one of the higher income tax brackets. The max AMT rate is 28% while the ordinary income tax rate maxes out at 37%. For a year where you have to pay AMT, any additional income that falls under AMT is taxed at the max of 28%. So let’s say that you’re in the highest tax bracket of 37%. If you have other income that could fall under AMT (like NSO exercises, a large stock bonus, or any other selling of short-term capital gain items), then it’d be advantageous to shift those things into the same year that you have to pay AMT. Then they’ll be taxed at 28% instead of 37%...thereby saving you 9% on taxes. This is effectively sheltering the income from a higher tax rate in the year that you have to pay AMT.
Wrapping Up
If there’s one thing you get from this article, it’s this: there are many opportunities to minimize your taxes and optimize your incentive stock options. You should work with your financial professional to create a strategy that works best for you. If you’d like some helpful tips regarding your personal ISOs or AMT situation, you may schedule an appointment here for free. This offer is subject to availability, so hustle on over and schedule before they’re all gone.
Did you find this article helpful? If so, make sure to share it with your coworkers...there’s a chance they need help understanding AMT too.
