In our last episode, we started our discussion on Incentive Stock Options (ISOs). Now, we’ll continue that discussion and dive deeper into Alternative Minimum Tax (ATM). Steve Moyer, vice president of executive compensation & corporate offerings, joins our host, Valerie Escobar, senior wealth advisor, to share more about the tax implications and strategies for ISOs and executive compensation.

Transcript

Valerie Escobar: If you joined us last time, we started our discussion regarding incentive stock options. If you did not join us, you should go and listen to it because I think today’s episode will make more sense. Would you agree, Steve?

Steve Moyer: Hopefully, yes.

Valerie: We are talking about incentive stock options, but also alternative minimum tax or the taxation in general that could occur in regards to these wonderful options that we might have.

I’m Valerie Escobar, certified financial planner with Mariner. You’re listening to Your Life Simplified, and I am joined again by Steve Moyer, VP of executive compensation and corporate offerings. Steve, thanks again.

Steve: Thank you.

Valerie: So, again, we talked about incentive stock options, which is the ability to purchase a stock. With my wonderful house example that I love to use, my neighbor’s house was worth $200,000. He said I could buy from him for $100,000. So, now, I’m like, “Okay, cool. I think I want to go ahead and do that, but how on earth do I pay for that house?” So, let’s start off with, let’s say, that for example, I say, “Okay, I want to buy that house, and I’m going to immediately sell the house so that I can get that $100,000 to give to my neighbor to make the transaction happen.”

Steve: Sure. Yeah, so in the stock option world, we would call that a cashless exercise. There’s two forms of cashless exercise. There’s a same-day sale. What that means is all of the options would be sold on the same day as exercise. And then, there’s a partial cashless exercise or what we would call a sell to cover. In other words, we would sell enough shares to help cover our costs, what we need to pay to acquire the shares, but we would hold the rest.

Valerie: Okay, perfect. If we have an incentive stock option and we do a cashless exercise, for example, let’s start with that, what happens tax wise?

Steve: Yeah, so just to back up a second, incentive stock options have the opportunity for favorable tax treatment. One of those opportunities is where all of the gain, what we talked about the last episode, the bargain element, all of that can potentially be taxed at long-term capital gains rates rather than ordinary income rates. And it can be a significant tax savings, 10%, 15% give or take, depending on somebody’s situation.

In order for that to happen, the incentive stock options, those shares have to be what we call a qualified disposition at the time of the sale. What that means is that those shares cannot be sold within two years of the grant date or within one year of the exercise date. If they are sold within those time frames, then they would be a disqualified disposition. If they’re sold outside of that or after those time frames, they would be qualified. Now, if they’re disqualified, that preferential tax treatment goes away, and the rules are that it would be ordinary income on the bargain element. When we’re talking about a same-day sale, exercise happens and the shares are sold right away, it’s a disqualifying disposition. The gain or the bargain element is ordinary income based on that bargain element at that time.

Valerie: Okay, perfect. We’re going to put a pin on a piece of that because what I’m hearing you say is disqualifying disposition means we’re going to pay higher taxes on that gain, but whether or not that’s always terrible is another point, right?

Steve: That’s right.

Valerie: First, before we go that direction, let’s say that I somehow have the cash to be able to buy my neighbor’s house, i.e., exercise my stock option without selling the house. If I do that, there’s just all my cash that’s hidden in the backyard. I go and I buy it. Now, I have a qualifying disposition, or no, I’m sorry. At that point, I’ve not violated the rules, so I can still be in this little safe zone.

Steve: That’s right.

Valerie: Of not paying ordinary income tax, right? But there is a thing called AMT. What is AMT?

Steve: Yeah, so AMT is the alternative minimum tax. And just think, there’s two different tax calculations. The regular tax, which is what most people are familiar with, and the alternative minimum tax. And what the AMT does is essentially makes sure that everybody pays their fair share in taxes, so to speak. So, both calculations would be done, and the taxpayer would pay the higher of the two.

Valerie: Perfect. And I want to talk again in numbers. So, let’s say that I make a $100,000, and my total tax is $15,000. How would I calculate my AMT, my alternative minimum tax?

Steve: Yeah, so the AMT is, again, it’s a separate tax calculation, but there’s certain things that may be included in the alternative minimum tax that are not included in the regular tax. For example, incentive stock options, the bargain element is not taxed for regular tax until the shares are actually sold. So, if somebody exercises and holds the shares, it’s not taxable for regular tax purposes. If the shares are held beyond the calendar year of exercise, it is what we call tax preference item for the alternative minimum tax. While it’s not recognized as income for regular tax, it is recognized as income for the alternative minimum tax. So, we would run both calculations, and again, the taxpayer would pay the higher of the two. But oftentimes, if somebody does have a significant amount of incentive stock options that are being exercised, so there’s a higher bargain element, oftentimes, we do see AMT start to come into play.

Valerie: Okay, perfect. So, I bought some stock. It’s worth $50 more than what I paid for it, but I’m holding that stock. And so, that $50 times however many shares, let’s say, it’s $50,000, I have to include that $50,000 on top of my regular paycheck to calculate my AMT. Is that what you’re telling me?

Steve: That $50,000 of gain would be included as a tax preference item for the alternative minimum tax. So, you’d have your normal income. The AMT calculation has some exemptions, similar to the regular tax system, but in the income calculation for AMT, the incentive stock option spread would be included in there. So, there’d be higher income potentially, which might mean that there’s the alternative tax.

Valerie: Okay, perfect. Not perfect because a lot of people, what they’ll say is, “Oh, great, I bought these. I exercise my options, I don’t actually get the money. It’s like I got a benefit, but there’s no actual cash. In fact, I had to outlay cash, and now, I have to pay taxes on that.” So, let’s talk a little bit about what do we do? What do we with AMT?

Steve: Well, so the good news is that if we’re having this conversation, it means that somebody has options, and it likely means that they’re in the money, which means that the price has gone up. So, there’s value there. That’s the good news.

Valerie: Yes.

Steve: When it comes to AMT planning, there’s really two approaches, I like to say. AMT avoidance is one, and the other is AMT management. Now, in some cases, if somebody has maybe one or two awards, they’ve done well and there’s value there, but it’s not millions of dollars’ worth of value, it’s possible that they could exercise over a number of years. And what we could do is exercise just enough so that AMT tax is essentially equal to the regular tax. So, we can avoid AMT altogether, and in some cases, it’s possible to exercise all of one’s options without having to face AMT. In other cases, there’s just a significant amount of… They’re really deep in the money, so there’s a lot of value there. Maybe there’s a number of different awards that have been granted, so a lot of shares, and it can get to the point where it may be impossible to avoid AMT. So, what we would then do is work to manage the AMT tax.

Valerie: Okay, perfect. And I think we talked a little bit about this is that everybody loves the idea of avoiding taxes. We totally get that. We want to help people, but at the same time, the main way to avoid taxes is not to make any money, and nobody wants that either. So, I think a lot of that conversation does say, “Okay, we’re going to avoid what we can, but really, it’s that management piece.” So, let’s accept that we made money, we have a good situation, we’re going to pay taxes on it. Let’s talk about management. So, what are some strategies around managing that?

Steve: Yeah, so a couple things. One is we want to avoid, if we can, what we would call an AMT phase-out. And if we get into the AMT phase-out area, it just means that we would pay a higher effective tax rate. So, we want to try to avoid that. We would exercise enough incentive stock options where we are paying AMT, but not so much where we would enter that phase-out range. We would try to avoid going there in the first place. We still manage how many incentive stock options. It’s just going to be more than the strategy where we’re looking to avoid it.

The other thing to note is that if somebody pays the alternative minimum tax because they’ve exercised incentive stock options, the amount of AMT that they paid is going to be available to them as an AMT credit, which means they can use that in future years to reduce their regular tax. It gets a little bit complicated, but the amount that they can use in a given year is the amount in which regular tax exceeds alternative minimum tax. And how things play out is when those shares are eventually sold, those incentive stock option shares that were exercised, most of the time, a significant portion, if not all of that credit, can be used at that point in time. So, the good news is that if AMT is paid, there is a credit available, which means that in future years, that credit can help somebody reduce their total tax liability. So, that’s part of managing the AMT is planning around the AMT credit and how to use that or capture that.

Valerie: Yeah. And making sure your accountant realizes that you’ve paid AMT in the past.

Steve: That’s right.

Valerie: That can be part of that calculation. Let’s talk about a couple of other little, I get pitfalls regarding all of this. Let’s say, what was it? Long-term capital gains. We have all these stocks, and we’re selling them, and we’ve waited the 12 months to be able to sell them. What could be some things that you’ve seen that could basically undo the long-term capital gains component? Like with wash sales?

Steve: Yeah. Okay. All right, cool. There’s some cases where somebody exercises and holds the shares expecting to pursue qualified disposition. Once they reach that mark, their plan is to sell the shares, pay long-term capital gains tax rather than ordinary income tax because there’s tax savings. It’s possible that after exercise occurs, the stock price drops in value, and if that happens, the value of the shares can be significantly less. In those cases, some folks can consider what we would call doing a disqualified disposition, selling the shares intentionally. And the reason is because the tax rules say that they would pay ordinary income, but they would pay ordinary income on the lesser of the spread at time of exercise or the spread at time of sale if that happens in the same year.

There’s some cases where, again, some of the exercises holds. The plan is to hold for a qualified disposition, sell the shares at that point in time. But because of what happens to the stock after exercise, it can make sense to actually sell the shares early, pay ordinary income, so a higher tax rate, but on a smaller spread, so they would pay less tax that way. Now, some have said, “Well, yeah, I’ll do that, and then, I’ll buy the shares right back.” They’ll hold them, and if the stock price, we expect it to come back, when it comes back, I’ll just pay gain on all of that gain at that point in time. It doesn’t quite work that way because there are wash sale rules that would apply. And with incentive stock options, the wash sale rules are nasty. It would say that somebody would pay ordinary income on that big spread at time of exercise, and so, they pay a higher tax rate on a large spread. So, you have to avoid wash sale rules when it comes to incentive stock options. Certainly would be not a fun event to go through.

Valerie: And I’ve seen some people run into wash sale rules unintentionally through other types of compensation.

Steve: Yeah. So, other things that can cause a purchase would be maybe there’s an employee stock purchase plan that somebody participates in and shares are purchased, or maybe they have restricted stock units or restricted stock awards that are vesting. Those can be considered purchases, too. It’s not entirely clear if those are deemed purchases for wash sale rules, but I think common consensus seems to suggest that they are considered. And certainly, the conservative route would be let’s not cross that line and find out the hard way whether or not that would be considered a purchase for wash sale rules. So, our approach would be to avoid disqualified dispositions if we know that there’s other purchases looming. And certainly, we would avoid repurchasing the shares on an open market if it’s publicly traded.

Valerie: Right, right. There’s just so many different pitfalls. Let’s say that we have our plan in place, and we have our incentive stock options, and we’ve purchased it, and we’re ready to sell it. We’ve exercised, and we’re ready to sell it. What happens if we decide to leave the employer?

Steve: So, it depends on the stock plan and the employer, but generally speaking, if we terminate employment, all unvested options are forfeited. They would be lost. And generally speaking, the vested options only have 90 days to be exercised. And if they’re not exercised, they would expire. So, that value could potentially be lost as well. In some circumstances due to, say, death or disability or maybe somebody’s retirement eligible based on how the company defines that, sometimes, they don’t forfeit everything or sometimes, they don’t forfeit anything. But with incentive stock options, even if the exercise or the expiration window is extended, incentive stock options must be exercised within 90 days or they would become non-qualified.

Valerie: Okay, perfect. Definitely these are meant to be retention tools.

Steve: Yes.

Valerie: Okay, perfect. Again, so many things to think about, making sure that your advisor is completely aware of your entire plan with all the different types of compensation that you have, and also, all the different types of income that you have, because that will help so much in making that AMT calculation and developing a strategy around that. You’ve been listening to Your Life Simplified. Be sure to ‘Like’ and subscribe wherever you are tuning in. And Steve, thank you so much for joining us.

Steve: Thank you.

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