Alternative minimum tax and stock options

In short

A friend of mine once exercised his stock options and felt rich for about a week. Then his tax preparer called with news he did not expect. If you hold incentive stock options, the same thing could happen to you. When you exercise them and keep the shares, the gap between your cost and the market price can be taxed under a second set of rules called the alternative minimum tax. You do not need to sell a single share for this to apply. Run both tax calculations before you exercise, not after. Keep your Form 3921 from your employer, and check Form 6251 and the IRS instructions to see how your numbers land.

The whole of it

What it is

I once sat beside a man at a county fair who told me he had two sets of books for his farm, and both were honest. I thought that odd until I learned about the alternative minimum tax. It is a second way of figuring what you owe, run alongside the regular way, and you pay whichever comes out higher.

Congress built it so that people with large incomes could not shrink their bills to nothing with deductions and special rules. It leaves out some of the breaks the regular system allows. It also counts some income the regular system ignores. Incentive stock options are one of the best known examples.

An incentive stock option, often called an ISO, is a right to buy company shares at a set price, called the exercise price or strike price. Your employer grants it, and special tax rules apply to it. A different kind, the nonqualified option, works another way, and the alternative minimum tax does not treat it like an ISO. This guide is about ISOs.

If you are holding options and wondering what the fuss is about, you are in good company. Plenty of careful people get caught off guard by this. It is not a sign you did anything wrong.

How it works

You have probably heard that ISOs get friendly treatment. That is true for regular tax. When you exercise, you buy the shares at your strike price. The regular tax system does not count the gain at that moment. You owe nothing on the paper profit until you sell.

The alternative minimum tax sees it differently. For that system, the spread counts as income in the year you exercise. The spread is the market price on the day you exercise, minus the strike price you pay, times the number of shares. It is a gain on paper, but the second system still counts it.

Here is the part that stings. That spread is not cash. You still own the shares, and you may not be able to sell them. Yet the tax bill can arrive in cash anyway.

After you add the spread and a few other items to your income, you subtract an exemption amount. The exemption is a set sum that shelters part of your income. It shrinks as your income rises and can phase out entirely for high earners. Then you apply the alternative minimum tax rates. The result is your tentative minimum tax. If it beats your regular tax, you pay the difference on top.

There is some kindness built in, though. If you pay alternative minimum tax because of an ISO spread, you may earn a credit. The credit can lower your regular tax in a later year. That helps, but it can take years to use, and it does not always come back in full.

One more rule matters a great deal. If you sell the shares in the same calendar year you exercise, the picture changes. That is called a disqualifying disposition. The spread then becomes ordinary income for regular tax, and the alternative minimum tax issue largely disappears for those shares. You trade one tax problem for another, so check the details with the actual forms.

The numbers, and where to find yours

Three kinds of numbers drive this. The first is set by law and changes each year. These are the exemption amount, the income level where the exemption starts to shrink, and the point where the higher alternative minimum tax rate begins. The current exemption amount is the current figure, which the official source publishes each year. The income level where it begins to phase out is the current figure, which the official source publishes each year. The alternative minimum tax rates are the current figure, which the official source publishes each year. The IRS publishes these each year, and the site fills in the verified figures with their source and date.

The second kind is the holding rule. The tax code sets two dates for ISO shares. A later sale gets long term capital gain treatment only if you have held the shares past both of them. One date is the current figure, which the official source publishes each year. The other is the current figure, which the official source publishes each year. Your plan documents will show your grant and exercise dates. The IRS instructions for Form 3921 and Form 6251 explain how ISO exercises are reported.

The third kind is your own. Your grant paperwork shows your strike price and share count. After you exercise, your employer sends Form 3921, which lists the exercise date, the strike price, and the market value on that day. The IRS describes the filing in the instructions for Form 6251, Alternative Minimum Tax for Individuals. If you carry a credit from earlier years, Form 8801 tracks it. All of these are on irs.gov.

A worked example

Let me tell you about a woman I will call Maria Santos. She is an engineer with a salary of 210,000 dollars. She holds ISOs for 10,000 shares with a strike price of 5 dollars each. The shares are now worth 25 dollars each.

The price she pays is 10,000 shares times 5 dollars, which is 50,000 dollars. The market value is 10,000 times 25 dollars, which is 250,000 dollars. The spread is 250,000 minus 50,000, which is 200,000 dollars.

For regular tax, that 200,000 dollars is not income this year. She owes regular tax only on her salary. For the alternative minimum tax, her income grows to her 210,000 salary plus the 200,000 spread, which is 410,000 dollars. This is a simplified look, since real returns include other adjustments.

Next the exemption comes in. Suppose, for this story only, the exemption is 80,000 dollars and it has fully phased out at her income. Then her alternative minimum taxable income stays at 410,000 dollars. Now suppose the rates are 26 percent on the first 200,000 dollars and 28 percent above that. These are plain story figures, not the current law.

The first piece is 200,000 times 26 percent, which is 52,000 dollars. The rest is 410,000 minus 200,000, which is 210,000 dollars. Times 28 percent, that is 58,800 dollars. Her tentative minimum tax is 52,000 plus 58,800, which is 110,800 dollars.

Now suppose her regular tax on the 210,000 salary comes to 40,000 dollars in our story. The alternative minimum tax is the amount by which 110,800 beats 40,000. That is 70,800 dollars.

Think about what that means. She holds shares she may not be able to sell yet. Still, she owes 70,800 dollars more to the IRS. If she had run these numbers in January, she could have exercised fewer shares. She could also have set aside cash. Maria would have been glad of the warning. She may also earn a credit, which could lower her regular tax in later years.

Where it goes wrong

A neighbor of mine had a hard lesson here, and I think of it often. The most common slip is exercising without running the numbers. The shares feel like a gift, and the tax feels far away. It is not.

The second slip is a falling share price. Suppose you exercise and owe tax on a 25 dollar price. Then the stock drops to 8 dollars. You paid tax on value that vanished. The credit may soften that, but it does not make you whole.

A third slip is thinking a sale solves everything. Selling in the same year can change the treatment, as noted earlier. But it also gives up long term capital gain treatment on those shares. It matters which rule you want to live under.

Fourth, people forget the cash. The bill is due even if the shares are locked up. Plan for where the money will come from.

Last, people trust a rule of thumb. Your own return depends on your other income, deductions, and state. A tax professional can run it with your real figures. The IRS Form 6251 instructions will show you the same steps.

Questions to answer before you leave this page

Do you know your strike price, your share count, and the grant dates in your paperwork? Have you looked up the exemption amount and phaseout level the IRS lists for this year? Have you worked out your spread, meaning market price minus strike price, times your shares? Can you estimate your regular tax and your alternative minimum tax side by side, and see which is higher? Where would the cash come from if a bill arrives before you can sell? Have you checked the holding dates, and do you know when a sale would count as a disqualifying disposition? Do you already carry a credit from an earlier year on Form 8801, and have you asked a tax professional to run your real numbers?