Tax Reform Muted the AMT: Holders of Incentive Stock Options, Take Note
- Alternative Minimum Tax
- Deterrent to Tax Shelters
- Tax Reform Changes
- Tax Deductions and Preferences
- Incentive Stock Options
- Tax Planning Opportunity
Although Congress, as part of the recent tax reform, promised to do away with the alternative minimum tax (AMT), it only did so for C corporations; as a result, the AMT still applies to individuals.
Congress originally developed the AMT in 1969 as a means to prevent high-income individuals from using tax shelters to reduce their taxes. For the AMT, federal income tax is calculated without certain deductions and tax preferences. This tax applies if it is greater than the regularly computed income tax. Although it has since been indexed to inflation, the AMT at one point began to apply to middle-income taxpayers, who are not the intended targets of this punitive tax.
The AMT computation includes a tax-exempt amount, but this amount begins to phase out for taxpayers whose adjusted gross income (AGI) exceeds a certain threshold (depending on their filing status). Although the tax reform did not eliminate the AMT, it did mute that tax considerably by increasing the AMT exemptions and by substantially raising the exemption-phaseout thresholds, as illustrated below. The exemptions and AGI phaseout thresholds will be inflation-adjusted in future years.
AMT EXEMPTIONS ($)
|Married Filing Jointly or Surviving Spouse||84,500||109,400|
|Single or Head of Household||54,300||70,300|
|Married Filing Separately||42,250||54,700|
EXEMPTION-PHASEOUT AGI THESHOLDS
|Married Filing Jointly or Surviving Spouse||160,900||1,000,000|
|Single or Head of Household||120,700||500,000|
|Married Filing Separately||80,450||500,000|
These are the tax deductions and preferences that most often affect the average taxpayer:
- Some itemized deductions are allowed for the regular tax computation but not for the AMT computation.
- Tier II miscellaneous itemized tax deductions are not allowed for the AMT computation; in addition, for the years 2018 through 2025, they are also not allowed for the regular tax computation. This category primarily includes employee business expenses, investment expenses, and legal fees. As these expenses aren’t currently deductible in either tax calculation, there is no adjustment for the AMT calculation.
- The AMT computation does not allow the itemized deduction for interest on home-equity debt; such debt also is not deductible in the regular computation through 2025, which eliminates another difference in the two computations.
- Employee incentive stock option tax preferences are also handled differently in the two computations, as is discussed in more detail later in the post.
As a result of the increased exemptions, the higher AGI thresholds for the exemption phaseout, and the reduction or elimination of differences in deductions, the AMT typically no longer affects average taxpayers.
Incentive stock options – Employers sometimes grant employees qualified stock options (i.e., incentive stock options), as motivation to become more involved in the company’s success and to share in the company’s stock appreciation.
For these options, the employer grants the employee an opportunity to purchase the company’s stock at a preset price on a future date. An option is usually accompanied by a vesting schedule that details the date when the options can be exercised (i.e., when the stock can be purchased). Once the employees has held these shares for more than a year—and for at least two years after the option was granted—any subsequent gains from sales of the stock are subject to the capital-gains tax instead of the ordinary (less favorable) income tax.
The Catch – The catch for incentive stock options is that, in the year when the employee exercises the option and purchases the stock, the difference (often referred to as the “bargain element”) between the stock’s current market value and the price that the employee paid as part of the option is treated as a tax preference. Thus, this difference is added to the employee’s AMT income but is not included in the regular tax income. In the past, this usually triggered the AMT, which meant that the employee had to pay tax on the phantom income in the year of the option, even though there was no actual stock sale. As a result, many employees have shied away from taking full advantage of incentive stock options; rather than holding the stock for the required qualifying period, they have been selling the stock in the year when they exercised the option, resulting in the profit being classified as ordinary income.
(Note that nonqualified stock options are not eligible for the beneficial tax treatment that incentive stock options are afforded. When a nonqualified option is exercised, the bargain element is included in the employee’s wages as ordinary income for the year when the option is exercised. However, this ordinary income is not a preference item for AMT purposes. Most employees who exercise nonqualified stock options immediately sell the stock so that they have money to pay the payroll taxes related to the resulting ordinary income. The paperwork that the employer provides when awarding the option states whether the option is qualified or nonqualified.)
Opportunity – The changes in the AMT present low- to moderate-income taxpayers with an opportunity to exercise incentive stock options without triggering the AMT.
If you hold incentive stock options, it may be possible to develop a plan—perhaps a multiyear plan—that will allow you to exercise your options without incurring phantom income in the AMT calculation. Please call this office for assistance in developing such a plan.