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Alternative Minimum Tax

Lesson in Course: Finance at work (advanced, 5min)

What is alternative minimum tax and how does it affect us?

Eureka!

What it's about: Alternative Minimum Tax and how it's calculated.

Why it's important: Waiting to exercise ISOs can put us at risk of owing AMT.

Key takeaway:  If we make more than $72,900 when filing single or $114,600 filing married, AMT can apply to us.

Alternative minimum tax was designed to prevent rich taxpayers from escaping their fair share of taxes owed through tax breaks. 

What is AMT ?

Alternative minimum tax or AMT is a floor set by the government on the percentage of taxes that a filer must pay to the government, no matter how many deductions or credits the filer may claim.

The complicated thing about AMT is that it often doesn't apply to most people. However, if we have incentive stock options, our chances of owing AMT increase.

Who does AMT apply to?

AMT is only calculated for folks who earn above a certain annual income or also known as the AMT exemption.

Earners above a certain income are targeted by the IRS for AMT

For the tax year 2020, the AMT exemption for individual filers is $72,900. For married joint filers, the figure is $113,400. For the tax year 2021, the figures are $73,600 for individuals and $114,600 for couples. We could be on the hook for AMT if we earn more than these exemption numbers. For those who live in coastal cities where the cost of living is substantially higher, the AMT exemption really starts for the middle class.

Just because we make more than the AMT exemption, doesn't mean we owe AMT tax. For AMT to matter, we need to theoretically be abusing tax write-offs. However, having ISOs and exercising our grants can also trigger AMT. 

Exercising incentive stock options

As a refresher, if we have ISO grants that qualify, we typically do not have to pay taxes on exercising. Instead, that tax is deferred to capital gains tax when we sell our shares.

Exercising ISOs at a hot startup can lead to AMT

However, there is a caveat. AMT is calculated separately from our regular income tax and will kick in if the amount owed for AMT is substantially more than our income tax. 

For ISOs, the potential taxable income applied to AMT is calculated based on the difference between the stock's current fair market value (FMV) and the strike price at the time of exercise. 

AMT calculation example

Let's assume we were granted 40,000 shares of ISOs with the strike price of ISOs: $0.20 We decide to exercise a quarter of our shares when the FMV is $30. The steps to calculate the potential income reported for AMT

  1. Calculate the difference between the FMV and strike price: $30 - $0.20 = $29.80
  2. Multiplied the difference by the number of shares exercised: $29.80 x 1000 = $29,800
  3. Add the income to calculate potential AMT liabilities

In the case above for AMT purposes we are showing excess income even when we haven't earned more. Depending on the income reported, the AMT tax liability can be larger than our income tax and we will need to pay the higher figure.

 

Being Handcuffed by AMT

AMT tax was imposed to close certain loopholes for the ultra-wealthy to avoid paying taxes; however, it also affects lucky startup employees who find themselves in very successful companies.

Employees have to stay at a company if they can't afford to pay the taxes owed to exercise 

AMT has prevented people from being able to leave their jobs and left them with golden handcuffs.

What is Golden handcuff?

When employees are unable to pay the tax to exercise their stock options and thus can’t leave the company without giving up the value of their equity

Early UBER employees couldn’t leave the company because the FMV of Uber stock had increased in value due to private investors, and the big price difference triggered AMT for everyone. If they wanted to quit, they would've had to forfeit the very valuable stock that they could not afford to exercise.

Actionable ideas

Even though we can estimate the AMT income reported, complex rules are in place that determines if it will actually be applied. For many of us, simple tax software like Turbotax only helps with knowing if our deductions trigger AMT. A tax advisor is needed to determine how much of our options we can exercise before triggering AMT. Alternatively, we can get ahead of AMT by early exercising. Be sure to read the Archimedes lesson on early exercising.

If we find ourselves golden handcuffed, a few financial institutions provide loans for employees to cover exercise tax. However, these loans can be expensive, and there is a risk to exercising that we need to think through.

Supplementary materials

For extra insight, check out the video by expert Mike Zung, CFP® over on the Watch tab!

Incentive Stock Options: Alternative Minimum Tax Explained!

Gain the confidence to make investing a bigger part of your life

https://app.getmedes.com/videos/incentive-stock-options-alternative-minimum-tax-explained/

Glossary

What is AMT ?

Alternative minimum tax or AMT is a floor set by the government on the percentage of taxes that a filer must pay to the government, no matter how many deductions or credits the filer may claim.

What is Golden handcuff?

When employees are unable to pay the tax to exercise their stock options and thus can’t leave the company without giving up the value of their equity