By Joe Ferreira and Sam Marshall, CPA
If you are reading this, you’ve probably either paid the IRS a significant sum in AMT from exercising Incentive Stock Options (ISOs), or you are a close family member of mine. (Hi Mom!) If you want to understand how you got into this situation, please go back and read the previous post on AMT which you can find here.
As mentioned in the previous article, any AMT paid due to exercising ISOs will likely be returned to you in the form of a tax credit. Great news, right? Unfortunately, the way the money is returned is not as straightforward as the IRS issuing you a check or sending you a prepaid Amazon gift card.
If you recall, you must pay your regular tax liability or your AMT liability – whichever is greater. However, if you have an AMT credit, you can use it to reduce your regular tax liability until it is equal to your AMT liability – essentially allowing you to pay the lesser of the two, as opposed to the greater! See our example below:
In the example above, you would use $10,000 of your AMT credit to reduce your tax liability from $25,000 to $15,000. Any additional unused credit would be carried forward to future years.
As you may have realized, the amount of AMT credit you get back each year is equal to the spread between your regular tax liability and your AMT liability. This spread is driven by a few factors, the most important of which is your income. The chart below illustrates the typical spread given various levels of taxable income.
The difference between the orange and the grey line is the amount of the credit you will receive. For example, if your taxable income were $200,000, your regular tax liability would be $30,818 and your AMT liability would be $23,556, allowing you to use $7,262 of your AMT credit. If you have significant investment income it gets a little more technical, but you can get an estimate from a qualified tax professional.
If your AMT credit generated in prior years is large enough, you may be looking at the chart above and rolling your eyes at how long it will take to use your entire credit. However, there is some additional good news! Selling the shares that originally generated your AMT will typically increase the spread between regular tax and AMT, allowing you to use more of your credit. You could still owe capital gains tax if the shares have appreciated significantly, but the credit will help soften the blow. The methodology for this is beyond the scope of this article, but we would be happy to walk anybody through the mechanics.
It is worth noting that even if you eventually get back every dollar you paid in AMT, there’s still a benefit in minimizing the amount you pay. By paying AMT, you lose the ability to use those funds immediately for other purposes. You are essentially giving the government an interest-free loan and reducing your ability to exercise more shares or use the money for another purpose.
Understanding these dynamics, along with your personal goals and resources, is critical for effective ISO planning. If you are wondering how to put a plan together, we’d be happy to help.