AMT & ISOs: What You Need to Know
One of the easiest ways to get tripped up with Incentive Stock Options (ISOs) is by misunderstanding the Alternative Minimum Tax (AMT). ISOs can be incredibly valuable, but because they’re one of the few things that can trigger AMT, it’s essential to understand how they work and how to plan accordingly.
What Is AMT?
The Alternative Minimum Tax is a separate tax system that runs alongside the regular federal income tax. It was originally designed to make sure high-income earners pay a minimum level of tax, even if they use deductions and credits that reduce their regular tax liability.
After the 2017 Tax Cuts and Jobs Act, far fewer people are affected by AMT, but exercising ISOs remains one of the most common triggers.
Why Do ISOs Trigger AMT?
One of the big tax advantages of ISOs is that if you hold the shares long enough, more than one year after exercise and two years after grant, you can qualify for long-term capital gains tax treatment on the entire gain above the exercise price. That could save you anywhere from 7% to 16% or more in federal taxes alone.
But that tax benefit comes with a catch.
The “bargain element” (the difference between the Fair Market Value at exercise and the exercise price) must be included in your AMT income in the year you exercise. That means you might owe tax before you’ve actually sold your shares or received any cash from them. In effect, you’re pre-paying tax on future gains and that can surprise a lot of people.
How to Avoid (or Minimize) AMT
There are two common strategies to avoid or reduce AMT when exercising ISOs:
1. Exercise and Sell in the Same Calendar Year
If you exercise your ISOs and sell the shares in the same year, you’ll avoid AMT altogether. However, the bargain element will be taxed as compensation income, not long-term capital gains. That means you’ll owe federal, state, and potentially Social Security and Medicare taxes.
This strategy can be especially useful if:
You were planning to sell anyway
You’re concerned about the stock price dropping
You don’t want to hold a concentrated position in your company
2. Exercise Just Enough to Stay Under the AMT Threshold
Each year, your AMT tax bill might be less than your regular tax bill. If you can exercise a portion of your ISOs that increases your AMT income without crossing the threshold where AMT is higher than your regular tax, you can:
Start the holding period for long-term capital gains
Avoid triggering AMT
This is where proactive planning (and tax projections) can really pay off. We help our clients run these calculations annually to strategically exercise ISOs over time and stay under the AMT radar.
What If I Already Paid AMT?
If you exercised and held your ISOs and ended up paying AMT, you’re not out of luck.
You may be eligible for an AMT credit, which can be used to offset future regular tax liability. In years where you don’t exercise ISOs, you’ll compare your regular and AMT tax amounts. If your AMT is lower than your regular tax, you may be able to use that credit to reduce your total tax bill.
The credit won’t disappear, but it can take years to fully use it, depending on how much AMT you paid and how your income fluctuates in future years.
Final Thoughts
AMT and ISOs are one of the trickiest combinations in tax planning. The opportunity to pay long-term capital gains tax instead of compensation income is appealing, but without a clear strategy, the tax surprise can undo much of the benefit.
If you’re thinking about exercising ISOs this year (especially in a volatile market or with a potential liquidity event on the horizon), be sure to run a tax projection and understand exactly what you might owe. It’s one of the most valuable things you can do to protect yourself and optimize the value of your equity compensation.