ISO AMT IDK: Taxes y'all

Part 2 of the Employee Stock Options series.

  1. Valuing Lottery Tickets
  2. ISO AMT IDK: Taxes Y’all
  3. Minimizing Regret

Disclaimer: The following is for entertainment purposes only, this is what I do for fun. I am not a finance or tax professional, seek the advice of a professional for your unique situation. Ok, now read my opinions.

There are two types of employee stock options NSO (Non-qualified stock options) and ISO (Incentive stock options). NSO have a very straightforward tax treatment: difference between strike price and fair market value is counted as regular income. ISO have much more complicated rules, so I’ll explain what I’ve learned. I will not cover how selling them affects your taxes, and I will also assume that you do not sell your shares in the same year that you exercise them (in which case they are treated the same as NSO).

If your strike price is much lower than the fair market value, or if you have a lot of options to exercise, you may have to pay more taxes when you exercise. If you do have to pay more taxes, you will slowly recover the money over the course of a few years in the form of tax credits.

A tale of two tax systems

There are two parallel tax systems in the US: Ordinary Tax and Alternative Minimum Tax (AMT). The vast majority of people only know about Ordinary Tax, this is the system that you use to figure out how much you owe the government every year. Even though you never noticed it, AMT is quietly sitting in the corner, calculating how much you owe according to its system every year. At the end of the year, the government checks how much you owe according to both Ordinary Tax and AMT and uses whichever one is greater.

There are various differences between the two systems, but the most important one to startup employees is how they treat ISO exercises: Ordinary Taxes ignores them while AMT counts them as normal income. AMT calculates income from ISO exercises by taking the difference between the fair market value and your strike price, and multiplying it by how many options you exercise:

(Fair market value - strike price) * number of options exercised = income

How much will I have to pay?

This depends on how much you exercise, your income, and various other things. It’s complicated (again)! If your company uses Carta, you can login and use the “Exercise simulator”, which will give you a breakdown of how much it thinks you will owe (if anything).

If your situation is more complicated, you might be wondering stuff like, “What if I contribute to my 401k? How does long term capital gains affect AMT? How does AMT treat property taxes or mortgage interest?” I’m working on a more detailed calculator and tools to understand all of this, you can sign up to be notified when it’s ready.

How do I minimize my taxes?

Assuming you know you want to exercise your options, the best way to minimize your taxes is to use the calculators above to figure out how many shares you can exercise before AMT kicks in. If you exercise just enough to not trigger AMT, it won’t affect your taxes at all. If you can spread out your exercises across multiple years, you can minimize the chances of having to pay taxes according to AMT.

If you have options whose strike price is the same as the fair market value, you can exercise as many of those as you want and they will not increase your taxes. If you know you want to exercise your options and believe the valuation will go up, it may be a good idea to exercise them before the next 409a valuation (periodic valuations by a third party that sets the fair market value).

Oh no, I will owe taxes, now what?

I guess you have to pay them ¯\_(ツ)_/¯

But, all is not lost. Take the difference between the Ordinary Tax and AMT amounts, that is your AMT Credit. In future years where you do not owe AMT, you will be able to reduce your taxes using your AMT Credit. The catch, is that you will only be able to use the AMT Credit to reduce your taxes by that year’s difference between the Ordinary Tax and the AMT amounts.

Example:

You exercise your options in 2020. Your AMT amount is $5,000 and your Ordinary Tax is $4,000. The AMT amount is greater, so at the end of the year you will have to pay $1,000 more. Congrats, you now have a $1,000 AMT Credit.

In 2021 you do not exercise any options. Your AMT amount is $3,700 and your Ordinary Tax is $4,000. The Ordinary Tax amount is greater, so you do not pay anything extra at the end of the year. You can also use some of your AMT Credit:

Usable AMT Credit for 2021 (difference between Ordinary and AMT):
$4,000 - $3,700 = $300

Total taxes due (Ordinary - Usable AMT Credit):
$4,000 - $300 = $3,700

AMT Credit balance for future years:
$1,000 - $300 = $700

These are just example numbers, but you get the idea. It will take a few (or many) years to recover the extra taxes you paid in 2020, which isn’t great, but at least you eventually get the money back.

Summary

In short, if you know you are going to exercise your options, you can optimize your taxes:

  1. Exercise options every year, or as often as you can. If you did not exercise your options over a few years, you may have a largish pool of vested options to exercise. You should use the calculators to see how many you can exercise before triggering AMT.
  2. If you have vested options that have the same strike price as the fair market value, you should exercise all of them if you think the fair market value will rise.

If you don’t know if you will exercise your options or think it’s too risky, I will go over some common strategies to minimize your risk when it comes to exercising options and selling your shares in my next post.

Further reading

Now that you know how your options will be taxed, you should read some strategies you can take to minimize your risk of losing money. If you don’t know if you want to deal with any of this, read part 1 of this series, Valuing Lottery Tickets.

Other resources