The alternative minimum tax (AMT) ensures that individuals pay a minimum amount of tax. The AMT was created because some wealthy taxpayers were either paying really low tax rates or claiming a high amount of deductions to reduce their tax payment obligation. Different forms of income are all taxed at different rates – some at more favorable (lower) rates than others. If one’s primary source of income is from something like long term capital gains (historically taxed at rates much lower than regular income tax rates) then generally speaking this triggers AMT to ensure everyone pays their fair share of taxes.
AMT is a secondary tax calculation that only triggers in certain situations. Exercising incentive stock options (ISOs) is one situation where AMT income is greater than regular taxable income, which could trigger AMT.
In this article, we discuss:
- Who pays the AMT?
- How are AMT tax rates calculated?
- AMT exemptions
- Estimated AMT Taxes
- AMT Breakeven
Who pays the alternative minimum tax?
Generally speaking, if you have a higher AMT income due to exercising ISOs or if a large source of your regular income is taxed at lower rates (like long term capital gains), the AMT could apply to you. It’s important to understand the alternative minimum tax when making exercise decisions throughout the year, as it can impact what you owe.
Additionally, when we talk about AMT here we’re discussing it on a federal level. However, it’s valuable to consider where you live as there are currently five states that also have a state-level AMT that could impact you (California, Colorado, Connecticut, Iowa, and Minnesota).
Alternative minimum tax rates and how it is calculated
A secondary tax calculation based on your AMT Income (AMTI) will determine if you trigger the AMT. Your AMTI is your regular taxable income plus deferral items such as exercising ISOs, but with modifications to deductions/credits that are allowable for regular taxes. If the amount of AMT is higher than your regular tax liability, you are subject to paying the AMT.
AMT tax rates
There are two tax rates associated with the AMT: 26 percent and 28 percent. Everything below the AMT threshold is subject to the 26 percent tax rate and everything above the threshold is taxed at 28 percent (similar to the progressive federal income tax brackets).
The AMT threshold for the 2021 tax year is $99,950 filing single and $199,000 married filing jointly.
AMTI below the AMT exemption level is not subject to the alternative minimum tax. For the 2021 tax year, the exemption was $73,600 for taxpayers filing as single and $114,600 for married couples filing jointly. The AMT exemption allows you to treat that income as regular income, subject to deductions and credits you might claim. However, anything over the exemption is subject to the alternative minimum tax. After calculating what you owe from the AMT, you will pay the higher amount between the AMT income tax and standard income tax.
Let’s look at an example. A single taxpayer sells their ISOs and has an AMTI of $200,000. They would start by subtracting the exemption from their earnings ($200,000-$73,600). The amount remaining would be subject to the AMT rate of 26 percent to determine what they owe.
$200,000 (AMTI) – $73,600 (AMT exemption) = $126,400
$126,400 * 26% = $32,864 (amount owed via AMT)
The same taxpayer calculates their standard income tax like so:
$150,000 (regular salary) – $12,950 (standard deduction) = $137,050
$137,050 * [progressive federal tax brackets] = $27,104 (amount owed via regular income taxes)’
Since the amount owed from the AMT is higher than the amount owed from their regular income tax, this person will owe the AMT amount.
AMT exemptions for high earners
The AMT exemptions start to phase out at 25 cents per dollar earned once a taxpayer’s AMTI is above a certain threshold. In 2021, the exemption started phasing out at $523,600 in AMTI for single filers and $1,047,200 for married taxpayers filing jointly. Depending on an individual’s AMTI, their AMT exemption could either be reduced or eliminated and the remaining amount is subject to the 28 percent AMT.
Let’s look at another example. If a single taxpayer makes $550,000, they would subtract the threshold from their earnings ($550,000-$523,600) and then multiply the difference ($26,400) by .25. That amount ($6,600 in this scenario) is then subtracted from the AMT exemption level, thereby reducing it.
$550,000 (earnings) – $523,600 (AMTI) = $26,400
$26,400 x .25 = $6,600
$73,600 (AMT) – $6,600 = $67,000 (reduced exemption amount for this individual)
Estimated alternative minimum taxes
With your regular salaried income, your employer already pays estimated state and federal taxes for you. When it comes to other forms of income (like exercising ISOs), there are no automatic estimated payments made. Therefore, on any income subject to the AMT, you must make quarterly estimated tax payments. However, if your regular income tax payments meet the qualifications below, you can delay your tax payments on AMTI until it’s time for your annual tax filing.
Estimated taxes must be paid on AMT liabilities to avoid penalties unless:
- a) less than $1K is owed after withholdings
- b) 90% of the tax for the current year is paid
- c) 110% of the tax from the prior year tax return if you have enough current year withholding to cover that tax liability
If you do not want to trigger AMT when you exercise options, there are a certain number of shares (specific to your own financial situation) you can sell in order to avoid triggering it, assuming you’ve held the shares for at least two years from the grant date and one year from exercise. This happens because the AMT rate won’t exceed your regular tax liability. It’s known as the breakeven point because you’re maximizing the amount of shares you sell without going over and triggering AMT.
The calculation is: AMT “break even” = There is a point (x number of shares exercised) from which AMT will start to apply. Below that point (you exercise < x shares), you will not pay AMT, and above that point (you exercise > x shares), you will start triggering AMT.
Working around the alternative minimum tax can be tricky and knowing if you’ll trigger it isn’t always easy. Seeking the advice of an experienced financial advisor well-versed in the AMT is a great step in securing your equity.
How a tax advisor can help
Understanding the alternative minimum tax and knowing if (or how) you might be subject to it is not an easy task. Finding the right tax advisor for your situation is helpful in talking through potential AMT liabilities, running different scenarios with you to ensure you are minimizing your tax burden, and avoiding any penalties for not paying estimated taxes throughout the year.