Alternative Minimum Tax: The tax trap employees shouldn’t ignore

Receiving stock options as part of your compensation can be exciting, but it also comes with tax implications that aren’t always straightforward.

That’s because if you’ve been granted stock options, you might be caught by Alternative Minimum Tax (AMT). This article covers what AMT is, when it might affect you and what actions to take if it does.

What is Alternative Minimum Tax (AMT)?

Alternative Minimum Tax is a system that ensures high earners pay a minimum amount of tax, even after any deductions or advantages they might be owed. It acts as a backstop to prevent them from reducing their tax bill too much.

Why might you need to know about this as an employee receiving ISOs? Well, AMT might end up meaning you owe taxes when you exercise your stock options, even before you’ve converted those options into actual cash.

How AMT could result in a surprise tax bill

Think of AMT as a parallel tax system running alongside your regular income tax calculation. If your AMT calculation gives a higher tax bill than your standard tax calculation, you’ll be required to pay the AMT amount.

Startups typically offer stock options to incentivize employees and align their goals with the company’s success.

Employee stock options fall into two main types: incentive stock options (ISOs) and non-qualified stock options (NSOs).

Non-qualified stock options (NSOs) get taxed as income when they’re exercised, so there’s no risk of AMT being triggered.

On the other hand, incentive stock options (ISOs) have no income tax payable at exercise (that’s one of their benefits). But, if the stock’s value at the time of exercise is higher than the exercise price, the difference (aka the ‘spread’) could be taxed under Alternative Minimum Tax.

So, if you’ve received ISOs from your employer, that may create a surprise AMT scenario.

Let’s work through an example.

Imagine you’ve been granted 1,000 incentive stock options (ISOs) with the following characteristics:

• Exercise price: $10 per share
• Fair market value (FMV) at exercise: $50 per share
• Total exercise cost: $10,000
• Spread (FMV at exercise – exercise price): $40,000
• AMT rate: 28%

A few years after receiving your options, the company grows and you decide to exercise your options, paying $10,000 to buy the shares.

At this point, there’s no ordinary income tax (as they’re ISOs). But for Alternative Minimum Tax (AMT) purposes, the Internal Revenue Services (IRS) considers the $40,000 spread as taxable income.

If your AMT rate is 28%, you could owe $11,200 in AMT tax, even though you haven’t sold the shares or made any cash profit.

So, if the FMV at exercise is much higher than your exercise price, you’re more likely to owe AMT.

Employees can get caught off guard by this tax bill. This is why planning ahead is crucial. Understanding AMT can help you avoid unexpected taxes and make smarter decisions about when to exercise and sell your stock options.

How you can minimize the impact of AMT

Here are some ways you can minimize the likelihood of triggering an AMT scenario:

1. Exercise your ISOs gradually: Instead of exercising all options simultaneously, spread exercises across multiple years to stay below AMT exemption thresholds.

💡 The AMT exemption threshold reduces your alternative minimum taxable income (AMTI) before the AMT calculation kicks in.

If your AMTI stays below the exemption, you won’t owe AMT.

Source

Note: These figures won’t be valid after 2025, so make sure you check the up-to-date exemption amount.

2. Exercise early with an 83(b) election: If your company lets you exercise early (meaning you can buy the stock before the option vests), filing an 83(b) election within 30 days can help lock in a lower valuation and potentially reduce AMT liability. Here’s our guide on filing an 83(b) election.

3. Time your exercise strategically: If it’s possible, exercise ISOs during lower-income periods to avoid going over the AMT exemption thresholds.

4. Make use of AMT credits: If you’ve paid AMT in previous years, you can use credits to reduce future tax bills when AMT doesn’t apply.

5. Use an AMT calculator before exercising: Before making any moves, use an AMT calculator to estimate whether you’ll owe anything.

Since AMT can be complex, it’s essential to talk to a tax advisor before exercising ISOs. This can help you avoid surprises.

Stock options shouldn’t be complicated

Whether you’re incentivizing your team with stock options or need help navigating tax-efficient strategies, we’ve got you covered.

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