In the first part of this article (published in November) the foundations of the Alternative Minimum Tax (AMT) were established and I mentioned that, for taxpayers living overseas, the exercise of stock options often played a role in causing an individual to be subject to this tax.
Under the heading “stock options” the two main types are Incentive Stock Options (ISO's) and Nonqualified Stock Options (NSO's). However, as NSO's do not cause an individual to be in the AMT, the remainder of this article will focus on ISO's.
Technically an ISO is a contract from your employer that gives you the right to purchase the company's stock at a fixed price over a specified period. While ISO's must meet a number of criteria - on plan structure, option period, price, nontransferability, exercise amount and employment period - to qualify for favorable tax treatment, employers prefer these plans because they reward executives for long-term improvement in the company's performance and share price. Executives also find them appealing because they can make money in the market while deferring taxes until they sell the shares.
As long as the shares acquired through an ISO are held for at least one year following exercise and are not disposed of until at least two years after the option is granted, the difference between the option price and the sale price is taxed as a long-term capital gain. If you don't meet the holding-period requirements, the sale is a disqualifying disposition, and gains are taxed as ordinary income.
For purposes of the regular income tax, the exercise of an ISO is a non-event and there is no regular tax to pay at the time of exercise. Not so with the AMT, however, as the difference between the stock's option price and its fair market value on the exercise date (also known as the “spread” or “bargain element”) is treated as a preference item that increases taxable income for AMT purposes. Let's take an example (all amounts stated in USD):
Now assume that the working spouse exercises 7,000 ISO's when the stock's option price is $22 and the fair market value $41 per share. For regular income tax purposes nothing is reported and so the regular tax remains at $500. For AMT purposes, however, there is an adjustment of $133,000 which results in an AMT liability of approximately $33,000 (an effective tax rate of nearly 25%)! This at a time when the taxpayer may already be tight for cash because he has just laid out $154,000 to buy the shares and has to hold them for at least one year before he can sell them to be eligible for the long-term capital gain rate!
One strategy for avoiding this predicament is to exercise fewer shares each year, thereby minimizing the AMT exposure in any given year. For instance, in the above example if the taxpayer had exercised half as many ISO's the AMT adjustment would have been $66,500 and the AMT liability would have been $11,500 (an effective tax rate of only about 17%).
It should also be noted that because the bargain element is an AMT “deferral” preference (one that reflects a temporary difference between your AMT and regular-tax income), the AMT which you pay in the year in which you exercise the ISO's will generate a credit that can reduce your regular tax in the future. In the best case, the AMT credit will eventually permit you to recover all of the AMT you paid in the year in which you exercised the ISO's. If that happens, then the only effect of the AMT was to make you pay tax sooner, not to make you pay more tax than you would have paid. But for various reasons you cannot count on being able to recover all of the AMT in later years and even in the case where you can recover all of the AMT which you paid, it could still take many years to do so.