What is the AMT?
The alternative minimum tax is a parallel tax code that was originally conceived in order to prevent high income individuals from paying too little taxes by utilizing certain deductions available to them.
When an individual earns more than the exemption amount in the current tax year, the individual is responsible for calculating the AMT tax alongside (parallel to) the regular tax. After calculating the AMT tax, the individual must pay the higher of the two: either AMT or regular tax.
With AMT, many of the deductions that are available to you in the regular tax scheme are removed and must be added back to calculate the tax. The idea is that there is a floor, or “minimum” tax that an individual will always be subject to in order to ensure that there is a large enough tax bill for the IRS.
How to calculate AMT?
To calculate the alternative minimum taxable income (AMTI) you must take your regular income and add back certain deductions (such as those pertaining to state and local taxes, personal property taxes, interest income on private activity bonds, etc.) There is a plethora of deductions that must be added back to arrive at AMT, but the most relevant for you may be the inclusion of the spread on an ISO. We have another article that describes ISOs at greater length, found here.
After calculating AMTI you can reduce the figure by the exemption amount that applies to your particular income. The following table outlines the exemption amounts for different scenarios:
It is important to note that the exemption eventually phases out above certain income levels at a rate of $1 for every $4 of income above the following thresholds:
Ultimately, the AMTI after the exemptions will be subject to either of the two tax rates below depending on the individual's scenario:
Impact on ISOs
Incentive stock options (ISOs) are special in that they normally receive favorable tax treatment with only one taxable event under the IRS prescribed course of actions. However, even under the prescribed course of actions set by the IRS, the exercise of the options and the disposition of the stock must occur in different calendar years. This requires a preference item (defined below) to be added into the calculation of AMT in the year of exercise.
The preference item is the spread between the fair market value (FMV) of the stock on the day of exercise and the grant/exercise price defined in the original option. This differs from the regular tax scheme which does not take into account this spread.
Whether this additional item added to AMT impacts the actual taxes that the holder pays will depend on the holder’s total income for the year after accounting for the AMT adjustments. Therefore, in some scenarios this spread may have no impact or it may lead to a higher tax bill.
A way to avoid paying AMT in the year of exercise is to sell the stock in the same year; however, this also has a downside as it will turn the transaction into a disqualifying disposition (meaning that regular/ordinary income taxes must be paid on the spread), thereby losing the tax advantage gained by meeting the prescribed requirements.
AMT Tax Credits
The IRS deems that certain items such as deferral items, (which includes the aforementioned spread on ISOs in the year of exercise), may be used to generate AMT tax credits to be used in future years. These credits can be applied to future AMT calculations in order to reduce the overall liability.
While they’re worth mentioning, we also want to note that these credits can be complicated to calculate and are highly dependent on the individual’s situation and therefore should be arrived at through either professional tax advice or professional tax software.
Still not sure what the AMT means for you? That's ok- contact us here or read more about options here.