Incentive Stock Options: Alternative Minimum Tax Explained! - YouTube

If you have incentive stock options then there's  something called the alternative minimum tax  

that you really need to understand. It may seem  big and scary but today we're going to break down  

what AMT is, the reason why it even exists, why  you need to think about it whenever you have ISOs,  

some planning opportunities, and then also  the AMT credit. Alright, let's get started.  

Before we get too far into this, it's important  to understand the basics around incentive stock  

options and the way that they're taxed. I did  another video that talks about that so if you  

haven't watched that then I would encourage you  to watch that first then come back to this one.  

But more specifically around what we're talking  about here with AMT, it's about exercising your  

options and the bargain element. So I'll  do a quick explanation of what that is.

If we walk through an example kind of similar  to what I did in the last video. Assume that  

we have been granted a thousand ISOs and it has a  $10 strike price or exercise price then whenever  

you actually exercise it then you take the  difference between the price, the strike price,  

and the actual value of it that day that you  exercise it. So in our example we have fifty  

dollars and the strike price is ten dollars so  then the difference between those two is forty  

dollars per share and you multiply that by the  thousand ISOs that we just turned in the stock  

and then that gives us forty thousand dollars and  that is called the bargain element. In the last  

video, I talked about how if you exercise  here and then you wait more than a year  

before you sell it then there's some tax benefits  to that. But with the bargain element here,  

the reason why I'm pointing it out is that if  you exercise in a year but then you don't sell  

within that same calendar year, then this bargain  element gets plugged into the alternative minimum  

tax calculation. So let's go through that now. I  think the best way to explain AMT and the way that  

it works is to first walk through real quickly of  the way that your regular tax calculation works.

At a high level you take your gross income, so  just you just think of that's the money that  

you make, and then that is you subtract out any  adjustments so that would be things like student  

loan interest or HSA contributions or regular IRA  contributions. Then your gross income after your  

adjustments gives you adjusted gross income and  then after that you subtract out deductions so  

that would either be your standard deduction or if  you itemize then that's whenever this gets taken  

out and then that number gives you your taxable  income and so with your taxable income this is  

where the normal math happens where the first bit  gets taxed at 10 percent then you multiply the  

next by 12 percent and you go up the tax brackets  from there. Then after you do that math then that  

gives you something called your tentative tax. And  then from that you subtract out credits, so if you  

have kids then that's whenever the credits get  taken out, and then the final number that you get  

is called your total tax and that's just how much  you owe in taxes. So with this regular system,  

what was happening is that there were certain  scenarios where people were actually making a lot  

of money but were able to use this system in a way  to where they actually didn't have to pay a whole  

lot in taxes. So in the 60s the government said  hey we need to figure out a way to close these  

loopholes and so what they did is they created a  whole parallel tax system and they called that the  

alternative minimum tax. Now let's do a real quick  version of how the alternative minimum tax works.

And so the way that it works is that you take this  taxable income number here and then you drop it  

into the top of the AMT calculation. Then they say  it's like "hey let's add back either the standard  

deduction or if you itemize then it adds back some  of it". So it'll add back like state taxes and  

local taxes, so that gets added back and then you  also add these other things called adjustments and  

preference items. I put a star here because what I  talked about before with that ISO bargain element,  

then that's where this gets added here. So that's  why you can trigger AMT with your ISOs because  

there's income here that isn't included in this  formula at all. Once you add those back then  

there's just this flat amount that you subtract  out called the exemption and then that will give  

you your alternative minimum taxable income.  Similar to here you do another this is where you  

do the math again and you multiply it by the tax  rates here although amt there's just two tax rates  

and then that will give you another number for  tentative tax. The last thing that you do is you  

compare your tentative tax on your regular return  against your tentative tax in the AMT system.  

Whichever one is the higher one is  the one that you're going to pay.  

Let's walk through this with our example. So let's  say that in the regular tax system that whenever  

we go through this that we get to here and then  our tentative tax is thirty thousand dollars.  

But since we exercise some ISOs and we've carried  them over through the year then that bargain  

element gets added here and so we'll just say in  our same example that we run through this parallel  

calculation and then our tentative tax here comes  out to 35,000 dollars. Whenever this happens then  

you pay whichever one is the higher one so in this  scenario, you would pay the 35,000 dollars and the  

way that they would do that is they would just  add another five thousand dollars underneath the  

tentative tax here and that would be your there  would be a five thousand dollars of AMT here.

Now let's talk about some of the planning  opportunities with this. The first one is  

if you know that you're going to be exercising  ISOs then you want to know what this number is  

going to be because otherwise you could get  really surprised by the amount of AMT that  

you would expect to owe and you don't  want to be caught off guard with that.  

You'll probably need a tax professional or  a financial professional that understands  

this information to be able to help you with that  but it's good to know that just so that you're  

not caught off guard. Then the second planning  opportunity is actually there's a way that you can  

exercise stock options without having to pay  any AMT. So let's break this down real quick.  

Every year you're actually doing both of these  calculations, you just might not know it. But in  

a normal year whenever you don't have any of these  kind of special things here then this tentative  

tax on your normal taxes is higher than your AMT  tentative tax. So let's just say in our example  

that we have 30,000 dollars here and then this  one without any of these adjustments is 20,000  

dollars. Well what that's saying is that you can  actually start exercising some amount of ISOs  

and you can increase this tentative tax but make  sure that it doesn't go over this and so that  

you can actually do an exercise without paying  any sort of AMT. There's one final thing that's  

really important and it's called the AMT credit  and in this scenario whenever you've exercised  

stock options and that it's caused you to have  AMT, this amount can get used as the AMT credit.  

Generally the way that the AMT credit works  is that in future years whenever you're not  

exercising ISOs you're still doing these two  calculations like I was saying but then in the  

years that your regular tax is higher than your  AMT, your alternative minimum tentative tax,  

then you can actually use some of this credit  here to lower your next year's income. Now it's  

not as super straightforward as just saying okay  you can just take that five thousand dollars and  

get it all back the next year. So it's possible  that it takes multiple years to get that credit  

back. But the nice thing is that this credit never  expires and so you're able to carry it forward  

indefinitely until you use it all up. Alright,  so that's it. Thanks for sticking with me.  

If you were able to get something out of this  then I feel like we can explain anything here.  

If you like what you see then please consider  subscribing to my YouTube channel or go to  

javawealth.com if you want more information  and then I will talk to you guys later.

Thanks!