Protecting Employees From the Alternative Minimum Tax Trap

Incentive Stock Options (ISOs) are a common form of equity compensation often seen in early-stage startups. As an equity compensation administrator, it is important to understand the tax benefits, as well as the pitfalls associated with this form of equity compensation. 

As your company valuation and employee base grows, the likelihood that you will be presented with questions from employees about their stock options dramatically increases.  Though it is not your responsibility to provide personalized tax nor financial advice to employees, an area where they often fail to ask the right questions is around the topic of alternative minimum tax (AMT).  In this article we aim to deepen your understanding of AMT and provide you with information and strategies you can use to educate your employees on their equity compensation.  

THE EMPLOYEE PERSPECTIVE 

If you are a startup employee that has been granted ISOs as part of your employment, among the many factors you should consider when contemplating the impact of exercising your options is AMT.  One of the specific advantages of ISOs is that taxes are not due at the time of exercise, but that does not mean that you will not owe taxes later.  There are many unfortunate stories related to ISO exercises resulting in unexpected AMT liabilities, which we hope to help employees avoid.   

WHAT IS ALTERNATIVE MINIMUM TAX? 

Unbeknownst to many taxpayers, every time you file your taxes a calculation for AMT happens in the background.  “Under the tax law, certain tax benefits can significantly reduce a taxpayer's regular tax amount. The AMT applies to taxpayers with high economic income by setting a limit on those benefits. It helps to ensure that those taxpayers pay at least a minimum amount of tax.^”1 

In addition to limiting the benefit of certain deductions, the AMT calculation adds certain things to income that are not counted in your standard income tax calculation.  One of those items is the aggregate increase in value of your ISOs from your grant price to the fair market value, at the time of exercise.  With the AMT and standard tax calculation running coincidentally, you are required to pay whichever calculation produces the greater tax liability.   

SPREAD ON ISO EXERCISES 

To illustrate the ISO scenario that can trigger AMT, let us focus on Wendy, one of the first employees hired as a software engineer at a promising startup company.  As a part of her compensation package, she is granted 40,000 ISOs that vest over a four-year period. 

At the time of her option grant, the strike or grant price is $1.00 per share.  This means that once her options are vested, she can purchase shares at a fixed price of $1.00.  Fast forward two years and Wendy has vested 20,000 of her options.  Wendy feels very encouraged by the company’s progress and prospects for future returns and decides to exercise all her vested options at her $1.00 strike price. 

She pays $20,000 (20,000 options x $1.00 strike price).  At the time of her exercise, the new fair market value of a share of common stock is now $6.00.  Because these are ISOs, Wendy does not have to immediately pay tax on the $100,000 difference (20,000 shares x [$6.00 - $1.00]) between her strike price and the current fair market value of the shares.   This $100,000 is referred to as the spread.  

UNCLE SAM & AUNTIE SAMANTHA