Earlier we explored how stock options work in startups, today we dive deeper into certain tax traps to be aware of when exercising your options.
Although incentive stock options (ISOs) are generally more tax-friendly than non-qualified or non-statutory options (NSOs), ISOs can present alternative minimum tax (AMT) traps and cause unforeseen tax mishaps.
WHAT IS THE AMT?
The Alternative Minimum Tax (AMT) is a parallel tax system that requires certain people to pay more tax than their regular income tax. Although the AMT was intended to prevent those in very high tax brackets from using the special tax benefits to pay little or no taxes, the AMT has crept in and expanded its scope to apply to taxpayers who do not have very high incomes or claim special taxes. fiscal benefits.
HOW DO I KNOW IF I AM A TAXPAYER OF THE AMT?
This is the hardest part to figure out. But chances are, if you’re an AMT taxpayer, you know it because you’ve been an AMT taxpayer or came very close to doing so in the past. The easiest way to think of this is that if your income is around $52,800, or $82,100 for married filing jointly, in 2014 you should run your AMT calculations to see if you fall into AMT land. Note: These thresholds are reviewed annually.
Basically, what taxpayers (or their accountants) have to find out is if the regular tax is higher than the AMT amount and then the taxpayer pays the higher of the two amounts. To calculate AMT, the taxpayer must add back certain streams of income and eliminate certain deductions. One of those add-ons is the amount taxpayers must include when exercising (but not selling) their ISOs.
THE ISO TRAP
There are some potential pitfalls.
First of all, you may be pushed into the AMT regimen when you exercise your ISO. Exercising your ISO can push you into AMT if your company’s stock price appreciates significantly before (rather than after) the exercise. The spread between the exercise price and the value of the shares would be included in the AMT calculations.
Although the thresholds are generally for people earning more than $50k, a taxpayer can trigger AMT exposure because a large addition on their return can push the taxpayer over the edge of AMT land. This would be a hassle because now the taxpayer would have to recalculate their taxes for AMT purposes (e.g., add back certain income streams like ISO income, tax-exempt bond interest, etc. and minimize certain deductions like mortgage interest deductions, medical expenses). expenses, miscellaneous deductions, etc.) and file AMT Form 6251.
In addition, the taxpayer may also need to come up with the cash to pay their AMT! In essence, the taxpayer becomes responsible for paying taxes on income that has not yet been fully realized (ie, the taxpayer received the shares, but has not received the cash to pay the taxes due). Let’s say that on the exercise date, the taxpayer’s (Bob’s) strike price is $5, the FMV is $8, and Bob has 1,000 options. Bob’s full strike price is $5,000 and he may have to pay AMT for the difference between the FMV and his strike price, which is $3,000 ($8 x 1,000 shares-$5 x 1,000 shares). Actions). He may have exercised his ISO simply to start the capital gains clock, but he may have inadvertently triggered an AMT exposure AND you’ll need to raise the cash to cover it. You can see how problematic this can be when you work for a company that is doing very well and wait many years before exercising your options (the difference between the strike price and the FMV of the stock at the time of the exercise will be great).
The second trap is more likely to occur in a volatile market. To understand this, let’s continue with Bob, who exercised his ISO at a time when the stock price was high. Let’s say the value of his company starts to drop, so he chooses to sell his stock at $3 a share. Bob will not have made any economic gain on the sale since he paid $5 per share and sold at $3 per share, BUT on the exercise date he already paid AMT on the $5,000 when he exercised his ISO. This AMT that he paid in the year would earn an AMT credit that he can carry over, but if his regular tax never exceeds his AMT in later years, he may not be able to use this AMT credit that he earned. If his stock had continued to appreciate, he could have absorbed the AMT credit from him. Long story short, Bob paid income taxes that he never recognized and he may never get credit for those taxes that he paid.
WHAT SHOULD YOU DO?
Congress has made it clear enough that it doesn’t want taxpayers to avoid the AMT (so don’t bother trying), but there are a few things that can make your tax life less of a hassle:
Exercise early! The stock may be worth less, so the difference between the stock’s FMV and the strike price will be less, thus less AMT. Bonus benefit: This will get the capital gains time clock ticking as soon as possible.
Exercise the ISO early in the year and sell the shares later in the year. Any gain you make from the exercise and sale of the shares would be taxed as regular ordinary income. You could have taxable revenue from this sale, but at least you wouldn’t have the AMT/ISO problem and you’d have cash to pay any AMT liability you owe. Or you can choose to sell just a few shares to generate enough cash to buy the ISOs and pay any tax liability and keep the remaining shares as ISO (unexercised). This wouldn’t prevent the AMT trap, but at least you have cash to pay for your shares and your AMT taxes.
Be prepared to fall into the AMT if you wait to exercise your options. If you exercise the ISOs but don’t sell them until a few tax years later, even though the spread on the exercised options would fall into the AMT pool, the rest of the gain could likely be taxed as capital gains and you may be able to absorb some of the carryover. AMT credit to use later (again, AMT transfers are outside the scope of this post).
Which option is the best? None of these are quick fixes. It depends on the current and future value of the underlying stock, your overall financial status (eg, do you pay AMT anyway?), and your overall cash flow situation. Bottom line: If your ISO is in the money, consult your tax advisor first (particularly in a volatile market!) so you’ll be prepared for these ISO/AMT pitfalls.
IRS Circular 230 Disclosure: To ensure compliance with the requirements imposed by the IRS in Circular 230, please be advised that any tax advice contained in this release (including any attachments not explicitly stated to the contrary) is not intended to nor is it written to be used, and may not be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing, or recommending to any third party any transaction or matter addressed herein.