Alternative minimum tax was designed to prevent rich taxpayers from escaping their fair share of taxes owed through tax breaks.
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.
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.
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.
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.
AMT has prevented people from being able to leave their jobs and left them with golden handcuffs.
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.
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.
For extra insight, check out the video by expert Mike Zung, CFP® over on the Watch tab!