What is Alternative Minimum Tax?
The alternative minimum tax (AMT) is a provision of the tax code designed to obligate high-income taxpayers to pay at least a minimum amount of tax. When the AMT is triggered, a taxpayer must calculate their taxable income twice: once using the regular calculation and again to find their alternative minimum taxable income, which includes certain tax preferences and adjustment items that are excluded from the regular income calculation. Taxes are then calculated using both amounts, and the taxpayer will owe whichever amount is higher.
What triggers the AMT?
Several events can trigger AMT applicability. Among these are the exercise of incentive stock options (ISOs) that are not sold in the same year and the exclusion of capital gains from small business stock (QSBS) that was acquired before September 28, 2010, and held more than five years. The AMT excludes tax preference items like these. Proactive tax and financial planning is essential to protect the substantial tax benefits that purchasing and holding ISOs and QSBS can bring.
How can I minimize the impact of AMT?
For employees of pre-IPO companies who may experience intermittent spikes in taxable income, planning for the AMT is a must. While avoiding the AMT is generally preferable, this is not always possible. In those instances, however, carefully executed financial strategies can minimize your effective marginal tax rate, i.e., the percentage of the next dollar of earnings you will owe in taxes. Below are some ways you may be able to limit your total tax liability when the AMT comes into play.
Make annual income projections to inform your investment strategy.
A compelling benefit of ISOs is their preferential tax treatment. When you exercise an incentive stock option, the difference between the strike price and the stock’s fair market value, also known as the bargain element, is exempt from regular income tax. If you hold the stock for at least one year, all gains from the sale will be taxed at the long-term capital gains rate. For 2022, the long-term capital gains tax rate tops out at 20%, while regular income tax rates reach as high as 37%.
When you exercise and hold ISOs, however, the bargain element is includable in the AMT calculation. To get the most out of your ISOs’ preferential tax treatment, work with a trusted financial advisor to project your income each year. This will inform predictions of when you’re likely to become subject to the AMT, which can guide strategic decisions about when to exercise and sell shares.
Exercise ISOs at the end of the year.
At the end of the year, you’re in the best position to determine whether you’ll be subject to the AMT for that year. When you wait until year’s end to exercise incentive stock options, you can exercise and hold just enough of your options to keep your AMT tax liability from exceeding your liability under the regular 1040 calculation. Using this strategy, you may be able to exercise your ISOs over multiple years while avoiding the AMT.
Consider filing an 83(b) election.
One way to limit your potential liability under the AMT is to take advantage of Internal Revenue Code Section 83(b). This strategy is available for those who have ISOs in companies that allow early exercise of stock options. In this situation, you can choose to exercise stock options prior to vesting, when the strike price may be close to the stock’s fair market value, and to claim the associated tax liability in the current year. This results in a low bargain element, which minimizes the impact of the exercise on the AMT calculation.
Keep in mind, however, that making an 83(b) election carries inherent risk. Although pre-IPO shareholders generally expect the price of their stock to increase, there is no guarantee this will happen. In the event the stock price declines following an 83(b) election, there is no refund available for tax that was overpaid as a result of making the election.
Use the AMT credit wisely.
When you pay the alternative minimum tax on a stock option exercise, you’re paying taxes on unrealized gains. The tax you pay is carried forward as a credit toward the taxes owed on future realized gains. It can be used when your regular tax liability exceeds your AMT liability. The most common way to use the AMT credit is when you sell your company stock since the AMT cost basis is greater than regular income tax basis. Because the basis is higher, the gain is lower, and the tax for AMT purposes is also lower.
Absent a successful IPO, the AMT credit can take a long time to use, however, and depending on your future income, you may never be able to use it up. For this reason, it’s important to consult with a tax advisor with experience in the IPO process when determining when and how to use the AMT credit. The ideal strategy will depend on your tax bracket.
Consult with experienced tax and financial advisors.
U.S. tax law is complex and constantly changing, and the applicability of the AMT brings additional complexity. To protect your income from unnecessarily high taxation, you need the advice of experienced professionals who deeply understand how various tax provisions work together. A financial and tax advisor with extensive experience working with pre-IPO employees is in the best position to help you minimize your tax liability.
WRP specializes in helping employees and executives make the most of the opportunities that an IPO brings. For more insight and tips on how to navigate your company’s IPO, browse our blog and our free resource library.