Hot Topics: Exercising ISOs and the AMT - The Dual-Basis Concept

Introduction

When an employee exercises an incentive stock option (ISO), he pays no tax under the regular tax system; however, the spread between the exercise price and the fair market value of the stock at the time of exercise is usually income^[1] under the Alternative Minimum Tax (AMT).^[2] For example, if an employee holds ISOs for 1,000 shares at an exercise price of $1.00/share and exercises the ISOs when the stock’s value is $20.00, the $19.00/share spread on 1,000 shares or $19,000 is AMT income.

Note: You calculate the AMT as part of your Form 1040 income tax filing. All taxpayers are potentially subject to both regular income taxes and the AMT. The AMT is the excess of tax determined under the AMT regime over the regular tax owed. For example, if you owe $40,000 in AMT and your regular tax is $36,000, your AMT is $4,000. You report regular taxes of $36,000 and AMT of $4,000 on your Form 1040.

Under the regular tax system, you have a basis in your stock which is usually the amount paid for it (the option price). For example, if you acquired shares for $1/share, you will have a $1/share basis in the stock. If you then sell the stock for $101.00, you will report a $100/share gain, since your profit is the amount you receive, less your basis.

When you exercise ISOs, you will have AMT income whether or not you are subject to the AMT regime. Your stock basis is then increased by the AMT income. Thus you will have a dual basis, one under the AMT and the other under the regular tax system.

For example: Assume that you exercised 10,000 ISOs, paying an option price of $1/share when the stock was worth $101/share. Under AMT rules, your spread would be $1,000,000 and this amount is considered income under the AMT. Your AMT basis would be the option price of $10,000, plus the AMT income of $1,000,000. Suppose you hold the stock for one year and then sell it for $126/share. Here is what happens:

When the stock is sold, you report an AMT adjustment on Form 6251 with respect to the difference between the gain under the regular tax system and the AMT. Under this example, you would have a favorable AMT adjustment of $1,000,000 ($1,250,000 - $250,000 = $1,000,000), which can then be used first to reduce any AMT liability in the current year or will be added to your AMT credit for subsequent tax years.

For example: In the above example if you also had $1,500,000 of AMT income in the year you sold your stock, the adjustment of $1 million would reduce your AMT to $500,000. If your regular tax was $250,000 and your AMT was $140,000, the spread between your regular tax and AMT would be $110,000 and you could use your AMT credit (if available) to reduce your regular tax to $140,000 ($250,000 regular tax less $140,000 AMT = $110,000 AMT credit applied against your regular tax).

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AMT Credit

When you paid AMT because you exercised your ISOs, the tax paid could offset the taxes due when you sell the stock in a subsequent year. The tax paid under the AMT becomes a credit to be applied against your regular tax in a later year.

The exercise of an ISO is considered a timing issue because you are taxed on your stock under the regular system when you sell it; that is, at a specific time. Because ISOs involve a timing issue, you can apply the AMT credit against a later stock sale. The amount of the credit depends on whether the credit arose from such a “timing issue”. Your AMT credit has two components: (i) the amount of the credit; and (ii) whether the credit is available to use in the current year.

Unfortunately, the AMT credit cannot be applied against future AMT liability, the credit only applies when your regular tax exceeds your AMT liability, and then only to the extent of the difference.

For example: If your have a $100,000 AMT credit, a regular tax of $120,000 and an AMT liability of $80,000, you may apply $40,000 of your credit against your regular tax liability. Thus, you’ll pay $80,000 in taxes and will reduce your AMT credit from $100,000 to $60,000 for use in future tax years.

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AMT Credit – Capital Gains Issues

Let us assume you exercised ISOs for 10,000 shares at $101/share with an option price of $1/share, and as a result, you paid 28% tax on the $1,000,000 spread or $280,000 under the AMT. In the next year, you sell the stock for $101/share, giving you $1,000,000 profit, and pay 20% tax under the long-term capital gains rules, or $200,000. Your AMT credit applies to eliminate the $200,000 LTCG tax with an $80,000 AMT credit left over. Using this credit in subsequent years will depend on your situation, but it is clear that you did not gain the advantage of the LTCG rate of 20% when you sold the stock. In fact, you paid 28% on the transaction and whether you will ever recover the $80,000 difference is questionable.

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AMT Credit and Capital Losses

Assume the facts of the above example, except that in the next year, you sell your stock for $51/share. You’ll have a $500,000 profit under the regular system and a $500,000 capital loss under the AMT:

Regular Tax Amt Realized:                   $510,000 Less Basis:                        ($10,000) Gain:                                  $500,000

AMT Amt Realized:            $510,000 Less Basis:           ($1,010,000) Loss:                         ($500,000)

The AMT adjustment would logically be $1,000,000 (the difference between the gain under the regular tax system and the loss under the AMT) since the original AMT tax preference (the spread at the time the ISOs were exercised) was $1,000,000. However, the AMT capital loss is limited to AMT capital gains, plus an additional $3,000 per year.

The Result:There is an adjustment under the AMT of $503,000 (AMT capital gains of $500,000, plus $3,000) and a capital loss carryforward under the AMT system of $497,000. This capital loss may be used in future years as an adjustment under the AMT.

For example: If in year two, the taxpayer has a $400,000 AMT capital gain, your AMT capital loss carryforward of $497,000 would apply as follows: $400,000 AMT capital gain is offset with $400,000 of AMT capital loss carryforward, plus you are entitled to an additional AMT capital loss of $3,000. thus, your AMT capital loss for year two would be $403,000 and your remaining AMT capital loss carryforward of $94,000 would be available in a subsequent year.

 

The adjustment caused by the capital loss carryforward will increase the spread between the regular tax and the AMT, therefore, your AMT credit can reduce the regular tax in year two by the amount of the spread. When all is said and done, you wind up paying the AMT amount, rather than the regular tax.

For example: Assume your regular tax is $200,000 and your AMT is $120,000, then $80,000 of your AMT credit may be used in year 2 to reduce your tax from $200,000 to $120,000. Note: In a year in which the regular tax is higher than the AMT, you’ll pay the AMT amount (since it is lower than your regular tax), provided you have sufficient AMT credit to cover the spread between the regular tax and AMT.

 

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Conclusion:

The rules involving dual basis in stock, AMT capital loss carryforwards and use of your AMT credit are extremely complex and require accurate and extensive number-crunching with sophisticated tax software. Note that many consumer-based tax software programs do not adequately compute these values. Use of an experienced tax professional (who possesses the requisite “industrial-strength” tax software) is highly recommended.

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^[1] The spread is considered an “item of adjustment” under the AMT and this adjustment increases your AMT income. This article uses the term “AMT income” instead of “item of adjustment” although the concept is the same.

^[2] The U.S.income tax system has two separate systems, a regular tax that most taxpayers are familiar with, and a complicated AMT which was supposed to apply only to the wealthiest taxpayers who reduce their regular taxes by claiming deductions and exemptions permitted under the code. The AMT, however, was not limited to just the wealthiest taxpayers and those who exercise ISOs are also subject to the AMT. If an employee disposes of stock within the same taxable year in which he exercises the ISO, the spread is not subject to AMT. The transaction is considered a disqualified disposition and income is measured as of the date of sale. The Income is considered compensation and is taxed at regular tax rates.