Alternative minimum tax

In short

A friend of mine once told me he had paid every dollar of tax he owed, and then a letter came saying he owed more. If you earn a high income, or hold stock options, you may know that feeling or fear it. The alternative minimum tax, called AMT, is a second way of figuring your tax bill that runs beside the regular way. You pay whichever result is higher. Many people never meet it, and it is worth checking whether you are one who might. The IRS gives Form 6251 for running the second calculation, and both figures can be worked out before you exercise options or sell a big asset. That lets you talk about timing with your tax preparer, with real numbers in front of you rather than surprises.

The whole of it

What it is

I once watched a neighbor fill out two entry forms at the county fair, just to be sure he was in the right contest. The AMT works a little like that. You figure your tax the regular way. Then you figure it a second way, with a different set of rules. If the second number is bigger, you pay the difference on top.

Congress built the AMT so that people with high incomes could not use deductions and credits to cut their tax down to almost nothing. The idea is fair enough on its face. The trouble is that the second set of rules can catch people who did nothing sneaky at all. They simply held certain kinds of income or took certain deductions.

The tax is figured on IRS Form 6251, and the IRS explains it on its page called Alternative Minimum Tax. Those two are your primary sources, and they are worth reading yourself.

How it works

You have probably filled out a tax return and thought the math was already hard enough. The AMT adds a few more steps, but they follow a pattern you can learn.

You begin with your taxable income from the regular return. Then you add back certain items that the regular system lets you subtract. Common ones include the state and local tax deduction and part of the spread on certain stock options. The result is called alternative minimum taxable income, or AMTI.

Next you subtract an exemption amount. This is a chunk of income the AMT does not tax. The exemption shrinks as your AMTI climbs, and at high enough levels it phases out, which means it fades away step by step until it is gone. The exemption amounts and the income levels where the phase out begins are set by law and adjusted for inflation. They are the current figure, which the official source publishes each year and the current figure, which the official source publishes each year.

What remains is taxed at two rates. The lower rate is the current figure, which the official source publishes each year and the higher rate is the current figure, which the official source publishes each year. The higher rate applies to income above a set line, which is the current figure, which the official source publishes each year. Your result is called the tentative minimum tax.

Finally you compare. If the tentative minimum tax is more than your regular tax, you pay the regular tax plus the gap. That gap is the AMT. If it is less, you owe no AMT at all.

Stock options deserve a word. Incentive stock options, often called ISOs, are a type of employee stock option. When you exercise one, the regular tax system does not count the gain right away. The AMT does. That difference between the market price and what you paid is called the bargain element. It is the piece that so often sends an executive to Form 6251.

The numbers, and where to find yours

You may be holding a paystub or an option grant and wondering which figures matter. Here is where to look.

The exemption, the phase out threshold, the rate breakpoint, and the two rates all change with the tax year, or are set by law. The site fills those in above with a verified source and date. For your own return, the IRS instructions for Form 6251 list the current figures for the year you are filing.

Your regular taxable income is on your Form 1040. Your state and local tax deduction is on Schedule A. If you hold ISOs, your company sends you Form 3921 after you exercise. It shows the grant date, the exercise date, the price you paid, and the market value on the exercise day. Those are the inputs you need for the bargain element.

If you paid AMT because of ISO shares, you may have AMT credit to use in later years. The IRS calls this the Credit for Prior Year Minimum Tax, and it is figured on Form 8801. Keep those forms. They can matter for years.

A worked example

Let me tell you about a woman I will call Denise. She is a product manager, and she earned a salary of 250,000 dollars. She is single. This year she exercised incentive stock options on 5,000 shares. Her strike price was 10 dollars per share. The market price on the day she exercised was 40 dollars per share.

First, the bargain element. The market price minus the strike price is 40 minus 10, which is 30 dollars per share. Multiply by 5,000 shares. That gives 150,000 dollars.

Her regular return ignored that gain. For our example, say her regular taxable income came to 220,000 dollars after her deductions, and her regular tax came to 55,000 dollars. These are plain round figures chosen for the story, not real tax tables.

Now the AMT side. Start with 220,000 dollars of regular taxable income. Add back the 150,000 dollar bargain element. Suppose she also added back 10,000 dollars of state and local tax deduction. Then her AMTI is 220,000 plus 150,000 plus 10,000, which is 380,000 dollars.

Next she subtracts the exemption. Suppose, for the story, her exemption ended up at 60,000 dollars after the phase out. Then 380,000 minus 60,000 leaves 320,000 dollars to be taxed.

Now apply the rates. Suppose, again for the story, the lower rate applied to the first 200,000 dollars and the higher rate to the rest. If the lower rate were 26 percent, that piece is 200,000 times 0.26, which is 52,000 dollars. If the higher rate were 28 percent, the remaining 120,000 dollars is taxed at 0.28, which is 33,600 dollars. Add them. The tentative minimum tax is 52,000 plus 33,600, which is 85,600 dollars.

Compare. The tentative minimum tax is 85,600 dollars. Her regular tax was 55,000 dollars. The gap is 85,600 minus 55,000, which is 30,600 dollars. That gap is her AMT.

So Denise pays 55,000 plus 30,600, a total of 85,600 dollars. She did not do anything wrong. She exercised options, and the AMT counted a gain the regular return did not.

Here is the kind part of the story. Because she paid AMT on an ISO gain, the IRS rules may give her a credit for later years when her regular tax is higher than her AMT. She would track it on Form 8801. The credit can take time to use, so the cash she paid now is cash she will not have on hand.

Where it goes wrong

I have watched good people trip on this, and it is never because they were careless. It is because the rule is easy to miss.

The most common trouble is exercising a large block of ISOs and only learning about the AMT at tax time. The tax can come due even if you have not sold a single share. So you can owe real cash on stock you still hold, and if the price then falls, the tax you paid was based on a higher value. That is a hard lesson. Ask questions early.

Another slip is estimated taxes. If you expect AMT but do not pay enough during the year, you may owe a penalty. The IRS explains estimated tax on its page for Form 1040 ES. Check it.

A third slip is forgetting the credit. People pay AMT one year, then never claim the credit back in later years. Keep your Form 6251 and Form 8801 records together.

Also, do not assume the exemption is safe. It fades as income rises. A raise, a bonus, or a big sale can push you into the phase out without warning.

Last, state rules can differ from federal ones. Some states have their own version of a minimum tax. Check yours.

Questions to answer before you leave this page

Have you looked at last year's return to see whether Form 6251 was filed, and do you know why or why not? Do you hold incentive stock options, and have you found your Form 3921 so you can see the grant and exercise details? If you plan to exercise soon, have you asked your tax preparer to run both the regular and the AMT calculations first, using your real numbers? Do you know how much cash you would need if the AMT came due on shares you did not sell? Have you checked the IRS instructions for Form 6251 to find the exemption, phase out, and rates for your tax year? And if you paid AMT in the past, have you looked at Form 8801 to see whether you have a credit waiting for you?