Opportunity to Exercise More ISOs at No Tax Cost in 2018

Depending on your income level, you might be able to exercise more incentive stock options (ISO) with no tax cost due to the higher AMT exemption amount in 2018.

Fewer people will be impacted by the Alternative Minimum Tax (AMT) in 2018 due to changes found in the Tax Cuts and Jobs Act that was signed into law on December 22, 2017. This tax law significantly increased the amount of income exempt from the AMT.

Table – Alternative Minimum Tax Exemption Amounts

Year Unmarried Persons Married Couples Filing Jointly
2017 $54,300 $84,500
2018 $70,300 $109,400

As a result of the larger AMT exemption amounts, employees may be able to exercise more incentive stock options at no tax cost.

Refresher on AMT Implications of ISOs

The entire gain on an ISO can receive the preferential long-term capital gain treatment if two holding period conditions are met:

  1. The stock is not sold until at least 1 year following the exercise date
  2. The stock is not sold until at least 2 years following the grant date

If both conditions are met, the sale is classified as a “qualifying disposition,” with the increase in the stock’s value being taxed at the lower long-term capital gains tax rates (typically at 15% or 20%).

However, meeting the first holding period requirement can be difficult because there is a potential tax liability on the date of exercise due to the AMT. This tax is particularly burdensome because the employee ideally does not want to sell the stock for another year to get the preferential long term capital gain tax treatment. That means the tax liability due to the AMT has to be paid for without any cash proceeds from the options, which means coming up with cash elsewhere. That’s something that not everyone can afford to do.

The AMT can cause a tax bill in the year ISOs are exercised because the spread between the strike price and the value of the stock on the date of exercise (sometimes referred to as the “bargain element”), is included as taxable income for the AMT only. This spread is not counted as income in the regular tax calculation. That means if you exercise enough ISOs with a large enough spread, your AMT calculation is likely to be larger than your normal tax calculation, because it is involves a much higher total income amount as its starting point. With the higher AMT exemption amounts for 2018, it is likely that an employee can exercise additional options this year as compared to last year without triggering any tax bill under the AMT.

Example

This is a bit abstract, so let’s illustrate this with an example.

Paula is a single person earning $150,000 in wages. In 2017, she would have been able to exercise incentive stock options with a bargain element amounting to $16,250 without any additional tax cost due to AMT.

In 2018, assuming her salary stays the same, Paula can now exercise ISOs with a bargain element amounting to $25,600 without incurring AMT tax costs. That’s an additional $9,350 worth of ISOs that Paula can exercise at no additional tax cost.

Takeaways

Doing this calculation is called finding the AMT cross-over point. It’s a complex calculation that factors in a person’s income and deductions and unexercised ISOs. What we have done is find the point where the regular tax calculation and the Alternative Minimum Tax calculation are exactly equal. That means, any additional exercises of ISOs will cause a tax bill under AMT. It is especially crucial to analyze the spread (or “bargain element”) of the unexercised ISOs when performing this calculation.

In Paula’s case, she can exercise additional ISOs at no additional cost. This helps her get started on the holding period requirement for a “qualifying disposition” of her ISOs, without causing an unpleasant tax bill in the current tax year.

If you would like help figuring out how many ISOs you can exercise at no additional tax cost, we recommend working with one of our tax advisors.

 

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