What is Alternative Minimum Tax (AMT) and How Are ISOs Affected?

What is AMT?

AMT, or Alternative Minimum Tax, is a secondary federal tax system that runs parallel to the regular IRS tax system. Its purpose is to ensure taxpayers who receive too many deductions & tax breaks still pay a minimum amount of tax to the IRS. To calculate the AMT you owe, take your taxable income (Form 1040, line 15) and add back certain items (such as the bargain element of exercised ISOs) to get to your AMTI, Alternative Minimum Taxable Income. Subtract out your AMT exemption and multiply that amount by 26% for any amounts equal to or under $232,600 ($116,300 for MFS only) and 28% for any over. Do note if you have any income that is subject to capital gain rates (long-term capital gains or qualified dividends), for AMT purposes, those are still calculated at your long-term capital gain rate instead of the 26/28% AMT rate.

If the AMT amount calculated is greater than your regular tax liability, you will pay the difference as an extra tax. However, the amount of AMT paid will also be a credit you can use in future tax years. You would do the same calculation as above, and if you are under your regular tax liability, the difference is allowed against your carryover AMT credit.

AMT Exemption (2024)

However, once your AMTI is above a certain threshold, you will lose $0.25 of your AMT Exemption for every dollar above the threshold until it is phased out completely. Thus, even though long-term capital gain rates for AMT purposes are the same as for regular tax, once you enter the AMT phaseout range, you gain 7% of AMT for every extra capital gain dollar (25% of 28% AMT tax rate). See below for the AMT Phaseout numbers.

AMT Phaseout (2024)

What are the Add-Backs for AMT?

A few of the most common & relevant add-backs for tax-payers are

• Standard Deduction / State & Local Income Taxes (SALT)
• Bargain Element of Exercised ISOs 
• Tax-exempt interest for private activity bonds (e.g., stadiums)

You can find an exhaustive list from the IRS on the instruction page for Form 6251 here: https://www.irs.gov/instructions/i6251 

The Standard Deduction vs SALT add-back can create a unique tax opportunity where you may take the itemized deduction even if it is lower than the standard deduction. The 2024 standard deduction for a married couple is $29,200. For 2024, assume that your itemized deductions summed to $29,000. Normally, you would take the standard deduction and get a slightly higher tax deduction. However, if you elect to itemize your deductions even though the standard deduction is higher, instead of adding back $29,200 to your AMTI, you only have to add back $10,000 (since SALT is capped at $10k). Even though AMT paid is eventually reclaimed in future years through the credit, the opportunity cost, especially if the amount saved on AMT is large, can be worth it to compensate for the loss of regular tax deduction. 

How are ISOs affected by AMT?

As stated earlier, the bargain element of exercised ISOs is an add-back for AMT. For this example, assume you have 10,000 options of your company stock with an exercise price of $1.50. If the company stock is worth $100 today, your bargain element would be the difference between the stock’s current price when you exercise it with the actual exercise price ($100 – $1.50 = $98.50 per share). If you exercised all 10,000 options, you must add back $985,000 to your AMTI. This can lead to a very pricey tax bill due to all the AMT you owe.

However, this is only if you hold the stock past the calendar year you exercise it, typically to get qualifying disposition treatment. This is when you get long-term capital gain rates on the bargain element due to holding the stock for more than two years from the option grant and one year from the option exercise. If you decide to sell the stock in the same calendar year, it will be a disqualifying disposition, and you will not need to add back the bargain element to your AMTI. You will still owe ordinary income taxes on the bargain element.

If you sell your ISOs as qualifying dispositions (QDs), you may reclaim a large portion of the AMT credit you generated by the exercise. In the previous example, you exercised the stock at $1.50 when the stock was priced at $100. If the stock remains flat and you sell your ISOs as QDs, your cost basis will be $1.50, and you will realize $98.50 of long-term capital gain for each share. However, there is a separate Schedule D for AMT capital gains. Your basis for your AMT capital gains is the original cost basis added with the bargain element. Thus, you will have a $0 capital gain for the AMT Schedule D. This will create a significant difference in your regular tax liability & AMT liability, thus allowing you to regain most of your credit.

Unfortunately, there can be scenarios where you cannot utilize all of your extra AMT cost basis. This happens when the stock falls in value after you exercise. If the stock dropped to $50 after you exercised when it was $100, you would instead have a $50 AMT capital gain loss for each ISO you sell. Just like the regular Schedule D, you can only offset your AMT income by up to $3,000 in AMT net capital losses. In this case, you would carry over your AMT capital loss for future tax years, which can then be used for any capital gain transactions you have in the future.

Future of AMT if TCJA Sunsets

The Tax Cuts and Jobs Act of 2017 (TCJA) significantly increased the AMT exemption amount and Phase-out thresholds (see 2017 numbers below). Before the act passed, 5,000,000 taxpayers owed AMT in 2017. Afterward, only 200,000 taxpayers owed AMT in 2018. Since SALT is an add-back, due to the cap of $10,000, many high-income taxpayers lowered their AMTI due to the change (granted, they also had a much lower itemized deduction as a result). If TCJA were to sunset in 2026, we would see many more taxpayers again owing AMT.

AMT Exemption (2017)

AMT Phaseout (2017)

Sources

• IRS Topic no. 556, Alternative Minimum Tax
• Tax Foundation: 2024 Tax Brackets
• Tax Policy Center: How did the TCJA Change the AMT
• IRS Internal Revenue Bulletin: 2023-48

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