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Don't Vest And Forget: Incentive Stock Options and Alternative Minimum Tax Thumbnail

Don't Vest And Forget: Incentive Stock Options and Alternative Minimum Tax

If you're a tech employee who has been granted stock options as part of your compensation package, it's essential to understand the tax implications associated with these options. In particular, you may be subject to the alternative minimum tax (AMT) if you exercise incentive stock options (ISOs). This piece will explore the basics of incentive stock options and the alternative minimum tax.

What are Incentive Stock Options (ISOs)? 

Incentive Stock Options (ISOs) are a type of stock option granted to employees as an incentive to help align their interests with the company's performance. ISOs are granted with a strike price, also known as the exercise price, which is the price at which the employee can buy the stock when they exercise their options. The employee can exercise the ISOs and buy the stock at the strike price, and if the stock appreciates, they can sell it at a higher price and realize a profit.

One of the main benefits of ISOs is that they can receive favorable tax treatment compared to other types of stock options. Specifically, if specific requirements are met, the employee does not have to pay regular income tax on the difference between the strike price and the stock's fair market value at the time of exercise (referred to as the "spread").

What is the Alternative Minimum Tax (AMT)? 

The Alternative Minimum Tax (AMT) is a parallel tax system in the United States designed to ensure that high-income individuals, corporations, and certain taxpayers who claim a large number of deductions pay at least a minimum amount of tax. The AMT has a separate set of rules and rates compared to the regular income tax system, and taxpayers are required to calculate their tax liability under both systems and pay the higher of the two.

How Do ISOs Affect AMT? 

While ISOs can provide favorable tax treatment, they can also trigger the alternative minimum tax (AMT) for some employees. This can happen because the calculation of AMT includes the spread from exercising ISOs as part of the taxpayer's alternative minimum taxable income (AMTI), which is subject to AMT rates and rules. This means that even if the regular income tax on the spread is zero, the employee may still owe AMT on that amount.

The trigger for AMT with ISOs typically occurs in the year of exercise, when the spread is included in the taxpayer's AMTI. However, the actual tax liability under AMT depends on various factors, including the taxpayer's other income, deductions, and exemptions. Further, if ISOs are exercised, held to long-term capital gains, and sold, one may even receive an AMT credit (a reduction in AMTI). It's also worth noting that the AMT exemption amounts and tax brackets differ from those of the regular income tax system, further complicating the calculation.

How Can You Manage the AMT with ISOs? 

Managing the AMT with ISOs can be complex, but there are some strategies that employees can consider to minimize their AMT liability:

  1. Plan for Timing of ISO Exercise: Timing the exercise of ISOs can be crucial in managing the AMT. Employees may consider exercising ISOs in years when their regular income tax liability is high, which may offset the AMT liability. Conversely, if the regular income tax liability is low in a particular year, employees may consider delaying the exercise of ISOs to minimize the impact of the AMT.
  2. Multi-Year Laddering: As a part of full-vesting-cycle stock compensation planning, a strategy can be created over several years that optimizes the number of ISOs that can be exercised, held to long-term capital gains rates, and sold for divestment purposes and to capture the AMT credit.
  3. Monitor Your Income and Deductions: Since AMT is calculated based on a different set of rules and rates compared to the regular income tax system, employees may need to carefully monitor their other income, deductions, and exemptions to manage their AMT liability.

To wrap up, ISOs, and all forms of employee equity compensation, each have unique wealth planning impacts and considerations. Taken individually, they can be complex enough to the point of needing professional guidance. However, it is becoming more common for tech professionals to receive grants of multiple forms of equity compensation over their employment tenure. In all cases, it is recommended not to vest and forget by intentionally understanding and analyzing all equity grants and implementing a full-vesting-cycle strategy integrated with an overall wealth plan.


Matt Faubion, CFP®

Founder - Wealth Manager