When I first set out to write this article I intended to talk about how exercising stock options could cause a taxpayer to have to pay an Alternative Minimum Tax (AMT). This was until I realized that maybe some of us are not familiar with what the AMT is, at which point I decided it might be better to break the article up into two parts: the first part dealing with the concept of the AMT and the second part with the implication that exercising stock options could have on it.
The AMT is a second income tax system that runs parallel to the regular federal income tax system. First enacted in the late 1960's, the AMT was intended to target a small group of high-income individuals – who had managed to avoid all taxes – to ensure they paid a minimum amount of tax. Changes since the AMT's original enactment mean that today it reaches into the ranks of the middle class, potentially denying them the benefit of many of the deductions, credits, and lower tax rates available under the regular income tax system. The AMT also significantly increases the complexity of tax filing for taxpayers subject to the AMT and for millions of additional taxpayers who must complete AMT forms to make sure that they are not subject to the AMT.
The name “AMT” comes from the way the tax works. The AMT provides an alternative set of rules for calculating your income tax. In theory these rules determine the minimum amount of tax that someone with your income should be required to pay. If you're already paying at least that much (because of the “regular” income tax) you don't have to pay AMT. But if your regular tax falls below this minimum, you have to make up the difference.
Some of the items which cause Americans living in the U.S. to fall into the AMT are:
Of these items, usually only the first two (exemptions and standard deductions) play a role in throwing an American living overseas into the AMT and it is actually two other items – the exercise of stock options and the limitation on the foreign tax credit (FTC) – which play an even greater role. The first step in the analysis was to see what would happen to the couple's taxes should the housing exclusion be eliminated and if they chose to continue to rent their apartment. The conclusion in this scenario was that their taxes would rise by about US$300.
At this point, since I am planning on devoting the next article to stock options, I would like to talk about the impact of the FTC limitation which is best illustrated by way of an example. Here are the salient facts from an actual 2003 tax return which I prepared this year:
Under the regular tax computation this couple's tax liability was $7,533 before taking into consideration foreign tax credit. Hence, since they had available foreign tax credit of $10,254, they were able to reduce their regular tax to zero (with an excess FTC of $2,721 which they could carry forward to next year).
Under the Alternative Minimum Tax computation the couple's AMT tax liability was only $3,985 before foreign tax credit and so you are probably thinking to yourself that since their AMT liability was less than their regular tax liability AND since they had available foreign tax credit of $10,254 that they were in the clear. Right? Wrong! Because under the AMT rules you can only take a foreign tax credit of up to 90% of your AMT liability which, in this case, was only $3,586 ($3,985 x 90%). Consequently, this couple's AMT wound up being $399 ($3,985 - $3,586). Granted that they have more excess AMT foreign tax credit to carry forward to next year ($6,668 for AMT purposes versus $2,721 for regular tax purposes) but I think you will agree that this is little consolation when they are required to pay a resounding $399… today!
Admittedly I am leaving out the fact that this $399 will be available to the taxpayers as a credit in a future year if and when their regular tax exceeds their AMT tax. However, again, this doesn't completely mitigate the fact that they have to go out-of-pocket today.
As this example illustrates, even at a relatively low level of adjusted gross income and even where there are sufficient foreign tax credits, a person can still find himself in the AMT. Congress is studying ways to correct this problem, but until it does, almost anyone is a potential target for this tax.