How do you calculate the alternative minimum tax?
Basic Rules for ISOs
If you are subject to AMT all the time, this won't be a problem though but you won't get long term capital gains either. Simply stated, if you sell shares resulting from the exercise of ISOs within the same tax year as the exercise, you are no longer required to pay AMT on your phantom gains but pay ordinary income tax on your actual gains instead.
Since the cost of exercising stock options could already be very high, the addition of double taxation makes the entire investment more burdensome as well as risky. A solution for reducing this is risk is obtaining an advance from the ESO Fund to cover the entire cost of exercising your stock options, including the tax. An indirect benefit of letting ESO finance your option exercise is getting a disqualifying disposition that can eliminate much if not all of the AMT and reduce your overall tax liability.
Conceptually, ESO is making installment payments on your shares. Since your final installment value depends on the value of the stock at that time, you are in effect retaining unlimited upside potential while also deferring taxes on the phantom spread until those gains are actually realized.
The value of deferring is two fold. First, you actually have money for taxes when the realization occurs instead of pre-paying taxes on a phantom spread. Second, the time value of keeping tax dollars in your pocket can be quite exceptional since the average time to liquidity for startup companies has been increasing in recent years. If you exercised your ISO stock options earlier this year and are concerned with the tax burden next year, then ESO is an ideal solution since the AMT problem is solved AND your cost of the original exercise is also refunded to you.
The main catch is that your ESO transaction must occur during the same tax year as your option exercise in order to qualify for an AMT disqualifying disposition, so don't let December 31st creep up on you! No repayments are due under ESO's program unless and until there is a liquidity event involving the company that issued the shares, such as a sale or IPO. Even then, you are not at risk because repayment is never higher than whatever the stock is worth at that time.
See this page for more information on how to estimate the cost of paying AMT. With either kind of option, the employee gets the right to buy stock at a price fixed today for a defined number of years into the future, usually When employees choose to buy the shares, they are said to "exercise" the option.
The company gets a corresponding tax deduction. This holds whether the employee keeps the shares or sells them. With an ISO, the employee pays no tax on exercise, and the company gets no deduction. Instead, if the employee holds the shares for two years after grant and one year after exercise, the employee only pays capital gains tax on the ultimate difference between the exercise and sale price.
If these conditions are not met, then the options are taxed like a non-qualified option. There are other requirementsfor ISOs as well, as detailed in this article on our site.
But ISOs have a major disadvantage to the employee. The spread between the purchase and grant price is subject to the AMT. The AMT was enacted to prevent higher-income taxpayers from paying too little tax because they were able to take a variety of tax deductions or exclusions such as the spread on the exercise of an ISO. It requires that taxpayers who may be subject to the tax calculate what they owe in two ways.
First, they figure out how much tax they would owe using the normal tax rules. Then, they add back in to their taxable income certain deductions and exclusions they took when figuring their regular tax and, using this now higher number, calculate the AMT.
These "add-backs" are called "preference items" and the spread on an incentive stock option but not an NSO is one of these items. If the AMT is higher, the taxpayer pays that tax instead. One point most articles on this issue do not make clear is that if the amount paid under the AMT exceeds what would have been paid under normal tax rules that year, this AMT excess becomes a "minimum tax credit" MTC that can be applied in future years when normal taxes exceed the AMT amount.
The AMT amount, however, becomes a potential tax credit that you can subtract from a future tax bill. If in a subsequent year your regular tax exceeds your AMT, then you can apply the credit against the difference. How much you can claim depends on how much extra you paid by paying the AMT in a prior year. That provides a credit that can be used in future years.
The amount you would claim would be the difference between the regular tax amount and the AMT calculation. If the regular amount is greater, you can claim that as a credit, and carry forward any unused credits for future years. This explanation is, of course, the simplified version of a potentially complex matter. Anyone potentially subject to the AMT should use a tax advisor to make sure everything is done appropriately.
One way to deal with the AMT trap would be for the employee to sell some of the shares right away to generate enough cash to buy the options in the first place. So an employee would buy and sell enough shares to cover the purchase price, plus any taxes that would be due, then keeps the remaining shares as ISOs. For instance, an employee might buy 5, shares on which he or she has options and keep 5, But the employee will have more than enough cash left over to deal with this.
Another good strategy is to exercise incentive options early in the year. That's because the employee can avoid the AMT if shares are sold prior to the end of the calendar year in which the options are exercised.
John holds on to the shares, but watches the price closely. John is a higher-income taxpayer.