One of the most common areas where we see clients introduced to Alternative Minimum Tax is when Incentive Stock Options (ISOs) enter the financial picture. To learn more about AMT and how it is calculated, so you can avoid a shock, check our blog post from last week.
ISOs can be a tremendous benefit to creating wealth, but they are often misunderstood and can pack a large surprise if not appropriately planned for. Here are a few key terms to get us started:
- Grant Date/Amount– Original date and number of shares awarded
- Vesting Date– The date at which you are allowed to exercise your options
- Exercise Price– Price paid for options, usually discounted from the current share price.
- Bargain Element– Difference between exercise price and fair market value (FMV); drives potential AMT liability
ISO preferential tax treatment is attained when the shares are sold one year after exercise and two years after grant. When this criterion is met, the gains upon the sale will be considered long-term capital gains, as opposed to short-term gains which are taxed at current income rates.
Qualifying vs Disqualifying Disposition:
- Exercise and sell one year after exercise and two years after grant – AMT liability in the year you exercise, and gains are considered long-term capital gains
- Exercise and hold – AMT liability in the year you exercise but no additional immediate tax liability because the shares have yet to be sold
- Exercise and sell within one calendar year – no AMT liability and gains are taxed as regular income
- Exercise and sell within 12 months, across two calendar years – AMT liability in the year you exercise, and gains are taxed as regular income
- Exercise and sell more than one year from exercise but less than two years from grant – AMT liability in the year you exercise, and gains are split between regular income rates for the bargain element and capital gains depending on holding period
The AMT tax liability mentioned in the scenarios above is determined based on the difference between the exercise price and the fair market value (FMV) of the shares on the date of exercise. AMT may result in a larger tax bill than a typical year without exercising options and thus will directly affect your household’s cash flow. The good news is that when you end up paying AMT related exercising ISOs, you will likely receive an AMT tax credit, which can be used to offset your federal income tax bill in future years. This is a great reason why involving a CPA to help keep track of all the moving pieces is highly recommended.
The 83(b) Election is an alternative approach to divesting company stock. If your company allows, you have 30 days from the grant date to notify the IRS and your company of the 83(b) election. This involves paying tax on the exercise price from the grant at regular income rates; there would be no AMT implication and depending on when you sell the shares, you would later realize short- or long-term capital gains. For shares which you expect to increase in value, this can provide a fantastic tax break. This is however considered a risky approach because the shares could lose value and you would have overpaid on taxes by making this election.
Please reach out to us if you would like to work through your specific situation.
Disclosure: The material is presented solely for information purposes and has been gathered from sources believed to be reliable, however Merriman cannot guarantee the accuracy or completeness of such information, and certain information presented here may have been condensed or summarized from its original source. Merriman does not provide tax, legal or accounting advice, and nothing contained in these materials should be relied upon as such. Advisory services are only offered to clients or prospective clients where Merriman and its representatives are properly licensed or exempt from licensure. No advice may be rendered by Merriman unless a client service agreement is in place.
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Mike came to Merriman after several years spent in corporate finance and brought with him an innate sense of discipline. Whether surfacing through routine, structure, or a desire for predictability, discipline often guides his decision making. He enjoys helping clients determine goals and create a plan to achieve them. He sincerely believes you can accomplish all you set out to with the right structure and discipline.
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