Avoiding Alternative Minimum Tax

Many employers offer incentive stock options to their employees. These consist of providing the opportunity to buy corporate stock in the future at a fixed price. For the employer, the main advantage of offering this benefit is to inspire loyalty in the company: the more invested you are in the company’s success, the more likely you are to be fully committed to the organization, and they benefit from your diligence.

These benefits offer tax advantages when they are retained for an extended period, as doing so not only delays having to pay taxes on it, but also can impact long-term capital gain rates in a positive way. On the flip side, these advantages can be lost as a result of the Alternative Minimum Tax unless you exercise a strategic tax plan. In order to put yourself in the best possible position, it is important that you have a strong understanding of stock options and how they work.

What Are Stock Options?

A stock option can be either qualified, or incentive stock options (ISOs), or non-qualified. These two types are treated very differently from a tax perspective, so the distinction is an important one. Generally speaking, an employer will offer an employee the option to purchase a specific number of shares of their stock at a specific cost — this is known as the option price.

If you decide to go forward with buying the stock it is known as exercising your option. It does not matter what price the stock is trading at when the option date comes: the option price will apply, even if the stock’s fair market value is higher.  In most cases stock options are very specific in terms of when in the future they can be exercised; they are also sometimes awarded as a series of different prices and dates.

What are Incentive Stock Options?

When you are given Incentive Stock Options you get the benefit of being able to push the tax liability on the difference between the fair market value and your exercise price off into the future.  This means that employees are able to be taxed at the more advantageous long-term capital gains rates as long as they wait at least two years between the date that the option was granted and the date when they sell the stock, and it has to have been held for at least a year after having been purchased.

Unfortunately, the government still manages to use the AMT to disadvantage those who take advantage of ISOs. Even though the difference between the fair market value and the stock option price is not subject to regular tax, it is considered a preference item, and as such has to be counted as AMT income the same year that the option is exercised.  If the difference is substantial enough it is very likely to make the AMT, a special income tax calculation, kick in.

The AMT is used punitively to prevent high income individuals from taking advantage of certain tax incentives and advantages. When a person is subject to the AMT, they are required to pay higher tax rates, and in some cases this can be significant enough to eliminate the advantages of having an ISO. Still, there are other ways to address this issue, including creating an AMT credit to offset taxes paid in the future if the taxpayer has a year in which the AMT does not apply.

What are Non-Qualified Options?

Non-qualified options do not have the same tax advantages as ISOs. The financial benefit that they receive as a result of the difference between the price that they pay for the stock and the stock’s fair market value is treated as regular income. It is included on their W-2 at the end of the year and taxed as ordinary income, though when it is sold it gets special treatment: the proceeds of the stock sale need to be included on a Schedule D, and may represent either a gain or a loss due to market fluctuations or when sales costs are incurred.

Getting the Most Tax Benefit

There are a few ways that an ISO can be handled in order to avoid the AMT. If the taxpayer chooses to sell the stock in the same year that they purchased it, the difference between the price that they purchased it for and the fair market value will not be counted as AMT – it will simply be recorded as ordinary income.

Another method that may be helpful would be to break up the exercise of the ISO into small amounts over an extended period of time. Doing so reduces the AMT impact, while still retaining the other tax benefits.

The benefits of these options need to be carefully weighed and compared to the advantages of long-term capital gain rates. It is strongly suggested that you consult with a financial professional to ensure that you are choosing the option that is most advantageous for you.  If you’d like to discuss stock options and how they impact you, call our office to set up a convenient time to discuss them.

Have questions about your Employee Stock Options? Call us at (408) 990-3365 to set up a consultation.