Stock Options — AMT
In this one-part series on Incentive Stock Options (ISOs), I’m going to delve into the Alternative Minimum Tax (AMT). But first, let me tell you a story.
TL;DR
Taxes are an intentionally confusing, partisan mess, and exercising Incentive Stock Options makes them even worse. To explore your options (pun intended, sorry) and get ahead of the IRS, model your financial future with https://shouldiexercise.com.
My Friend Herb
My friend Herb used to work for a pre-IPO company. When Herb got his offer letter, he also learned that his company granted him 10,000 ISOs at a $3 strike price along with the standard 1-year cliff and 4-year vesting schedule. Five years later, the company went public, listing on the NYSE for $33/share. Bells were rung, bottles popped. Herb and his coworker Susan were having the time of their lives. But had he known about the Alternative Minimum Tax, Herb could have saved $70k+ from being locked up in taxes.
A week after the IPO, head still pounding from the residual Pol Roger in his system, Herb decided to exercise his stock options. He set up his account and clicked the button to pay $30,000 ($3/share * 10,000 shares). Herb was diligent about saving the $7,500/year needed to buy his options outright once they were fully vested.
Herb also knew that holding onto his shares for at least one year before selling would trigger long-term capital gains. Assuming the stock price stays at $33 in one year (by no means a guarantee), the capital gain on Herb’s stock would be ($33-$3)*10,000 = $300,000. Herb’s income of $100,000/year means he falls under the 15% long-term capital gains rate, resulting in a $45,000 tax bill when he sells the stock. The lifetime value of Herb’s options would end up being $255,000.
Conversely, if Herb were to buy and sell the stock immediately after the IPO, he would have had to pay regular income tax on the short-term capital gain. For brevity, I’ll only include the relevant tax brackets:
24% | $ 84,201 – 160,725
32% | $ 160,726 – 204,100
35% | $ 204,101 – 510,300Remember, Herb’s regular income is $100,000. With a $12,000 standard deduction, Herb’s $300,000 capital gain would break down into the table like so:
24% * $ 72,725 = $ 17,454
32% * $ 43,375 = $ 13,880
35% * $ 183,900 = $ 64,365
--------------------------
$ 95,699Capital Gain : $ 300,000
Lifetime Return : $ 204,301
Herb would have had to pay $95,699 to the federal government if he sold the shares immediately, so he chose to hold them for a year. Herb was ready to save over $50,000.
Blindsided by the IRS
Herb was well-prepared to deal with buying, holding and selling his stock options. What Herb didn’t know about was the AMT.
When you (read: TurboTax or mom’s accountant) file your taxes, you must actually compute them two ways. The first uses the regular tax bracket with which you’re likely familiar. But the second — and the reason you’re reading this — uses the AMT, or Alternative Minimum Tax.
If the alternative minimum tax is higher than your regular federal tax, then you must alternatively pay that minimum amount to the IRS. It’s a dastardly confusing name, because in reality you are required to pay the maximum of the two.
“Simple” AMT Example
Early 2020 now rolls around, and Herb is getting ready to pay his 2019 regular federal income taxes. His $100,000 income is reduced by the $12,000 standard deduction. His taxable income comes to $88,000. The federal tax brackets for 2019 were as follows:
10% | $ 0 – 9,700
12% | $ 9,701 – 39,475
22% | $ 39,476 – 84,200
24% | $ 84,201 – 160,725
32% | $ 160,726 – 204,100
35% | $ 204,101 – 510,300
37% | $ 501,301 +Based on this, Herb pays $15,294.50 in regular income tax in 2019. And since I always got in trouble for not showing my work in school, here’s how that was calculated:
10% * $ 9,700 = $ 970
12% * $ 29,775 = $ 3,573
22% * $ 44,725 = $ 9,839.50
24% * $ 3,800 = $ 912
---------------------------
+ $15,294.50This was the first way of calculating taxes. Next is the AMT.
Start the same way as before with the $100,000 income, but this time, instead of the $12,000 deduction, we exempt $71,700, leaving only $29,300 to be taxed. We then use the AMT tax brackets to calculate Herb’s AMT:
26% | $ 0 - 194,800
28% | $ 194,801 +All $29,300 gets taxed at the 26% rate, yielding $7,358. We can summarize this as follows:
Year: 2019 (filed in 2020)Regular | AMT | Required to Pay
-----------|--------|----------------
$15,294.50 | $7,358 | RegularTaxes Withheld from Paychecks: $15,294.50
Net Taxes Owed: $0
Remember that you have to pay the maximum between the regular income tax and the AMT. In this case, and in most cases, the AMT will not apply to people because of the large exemption.
However, we need to go back and revise our calculation for 2019, because Herb must include the unrealized gains on his ISO exercise when calculating AMT.
Instead of $29,300, Herb needs to use $329,300 against the same tax brackets above. The calculation:
26% * $ 194,800 = $ 50,648
28% * $ 134,500 = $ 37,660
--------------------------
+ $ 88,308What the $#(!. Let’s do that comparison again:
Year: 2019 (filed in 2020)Regular | AMT | Required to Pay
-----------|---------|----------------
$15,294.50 | $88,308 | AMTTaxes Withheld from Paychecks: $15,294.50
Net Taxes Owed: $73,013.50
Herb now finds himself in quite the bind, because he now owes $73,013.50 to the IRS, even though he has not yet made any money from the stock. What a sad day. The only way Herb can pay the bill is if he sells some of his shares.
A crude way to determine how many shares Herb must sell is to divide the amount he owes to the IRS by the price per share.
Shares to Sell = AMT Bill / Price per Share
= $73,013.50 / $33
= 2,212.5303
~ 2,213Herb can’t sell fractional shares, so we round up to 2,213. Herb sells those shares for $73,029, with a short-term capital gain of $66,390.
When 2021 rolls around, Herb will end up paying a 24% tax (using the regular income tax brackets) on the short-term capital gain, which ends up being $15,933.60.
When Herb sells his remaining 7,787 shares for long-term capital gains, he will pay in the 15% bracket for a total of $35,041.50.
Thus, Herb’s total taxes paid from trying to be financially responsible end up being:
Tax Amount
-------------------------
Short-Term $ 15,933.60
Long-Term $ 35,041.50
AMT + $ 73,013.50
-------------------------
Total $ 123,988.60Capital Gain : $ 300,000
Lifetime Return : $ 176,011.40
AMT Makes Amends
You may think to yourself at this point, Herb should have just bought and sold all his shares immediately! After all, $204,301 > $176,011.40.
You would be absolutely correct, except for the fact that there’s a saving grace with AMT. Whenever you pay AMT, the amount gets saved year-over-year as a credit applied to your regular taxes when your regular tax is higher than the AMT. Looking back at Herb’s base case regular vs. AMT calculation:
Regular | AMT | Difference
-----------|--------|-----------
$15,294.50 | $7,358 | $7,936.50If Herb has an AMT credit worth $73,013.50, then every year for the next ~9 years, Herb will get a federal tax refund of $7,936.50. Eventually, he will reclaim the entirety of the paid AMT, assuming he doesn’t trigger AMT in future years, which would bring his lifetime value back to $249,024.90, just shy of the $255,000 he planned for.
Waiting Aeons
Does Herb really want to wait 9 years to get all the value back from his attempt to get favorable tax consideration on his capital gains? Probably not. Is there a better way?
AMT doesn’t have to be as brutal as Herb experienced. There are ways to soften the blow if you prepare just a little more. Before a company goes public in an IPO, you still have to calculate AMT using the unrealized gains on any exercised ISOs. But there is a crucial difference in exercising ISOs in a pre-IPO vs. public company.
Fair Market Value
In a public company, the Fair Market Value of your ISOs is equal to the open-market share price. In a private, pre-IPO company, the FMV is set by the company itself, often as a result of a 409A valuation.
Without diving too deeply into those valuations, the net effect is that public companies often trade at 3–5x multiples of their FMV just months prior to an IPO. In effect, your AMT exposure will be significantly reduced when you exercise ISOs before an IPO event.
Let’s look back at Herb’s example, and suppose that in 2018 (1 year before he expects the company to go public), the FMV of his company’s stock is $7.
He chooses to exercise his 10,000 shares again for $30,000. But this time, the unrealized gain for AMT purposes is just ($7-$3)*10,000 = $40,000. Herb’s AMT can be calculated using the 2018 AMT exemption ($70,300):
AMT Income = Income + Unrealized Gains
= $100,000 + $40,000
= $140,000Taxable AMT Income = AMT Income - AMT Exemption
= $140,000 - $70,300
= $69,700AMT = Taxable AMT Income * 26%
= $69,700 * 0.26
= $18,122Regular | AMT | Difference
-----------|---------|-----------
$15,294.50 | $18,122 | -$2,827.50AMT Owed: $2,827.50
Now, Herb has already exercised all his shares. When his company IPOs, he can sell his shares for $330,000 and pay just 15% tax on the $300,000 capital gain. Since his AMT was so low for 2018, he is almost guaranteed to reclaim that as a credit in his 2019 tax return.
Are We There Yet?
Yes! Well, almost. Is Herb’s smartest choice to spend $30,000 over 1 year before a hypothetical IPO of his company? What if his company fails before that happens? He would be almost guaranteed to lose his $30,000 investment. Herb worked damn hard to save that money, and it could be gone in an instant.
Pre-IPO companies are inherently riskier investments. What if Herb’s company stays afloat, but never goes public? Will there ever be a market in which Herb can sell his shares?
Entire books can be written on this topic. Instead, why not use a tried-and-true method for solving problems: math.
After banging my head on a desk for the better part of the past two years reading through tax codes and trying to understand my own company stock options, I finally decided to make my findings available for others like me.
The Sell
I created https://shouldiexercise.com so that others like me can adequately model and understand their stock options and take control of their financial futures.
Try it out. Give your honest feedback. G-men please ignore all of the above.
