How AMT impacts the startup employee
In my last article, I wrote a bit about my own personal stock exercise strategy in a down market. The name of the game is essentially: wait and see, but I still feel confident enough in my employer that I want to fairly aggressively exercise my options. The key here is that I exercise up to the point where I’m about to start having to pay AMT. Which leads to a question that is easy to ignore until it’s way too late: what the heck is AMT?
The Alternative Minimum Tax
To put it as simply as possible, the US tax code actually includes two separate tax systems: the standard income tax, which is what most people pay every year, and a separate flat tax called the Alternative Minimum Tax, under which you would pay a flat percentage rate on all income you receive (26-28% depending on where your income falls). If you’re subject to AMT, you have to calculate your tax liability for both systems, and then you pay whichever amount is higher.
Ok, but why?
Well, as it turns out, the richer people get, the craftier they get about avoiding paying taxes. AMT was originally enacted in the late 1960’s because there were a whole bunch of high-income earners (i.e. north of $1M in today’s inflation-adjusted dollars) who were paying diddly squat in taxes. The government decided that the best way for the IRS to get their pound of flesh would be to levy a flat tax on all of these tax-dodgers’ incomes.
Naturally, the billionaires née millionaires have only gotten better at avoiding those taxes, but that’s a topic outside of the scope of this discussion.
Ok, so we’ve got this flat tax, and it only affects the millionaires and billionaires, so us normals don’t need to worry about it, right?
Well, as it turns out, Congress did a kind of shitty job when they originally crafted the AMT. There’s a handful of factors that influence whether or not you’ll get hit with AMT:
You’re only required to calculate your AMT exposure if you have certain types of income or deductions (think: stuff that tax dodgers might abuse in order to avoid taxation like depreciation or deductions of operating losses), or are above a certain income level
There’s a standard AMT exemption that is applied to help keep people from hitting AMT, which starts phasing out at around $500K of income (for single taxpayers)
The challenge here is that while standard income tax brackets are inflation-adjusted each year, the AMT exemption is not. So up until the Tax Cuts and Jobs Act, Congress had to periodically go back and pass legislation to update the AMT exemption to make sure that it wasn’t smacking too many Americans in the face each year. TCJA made some pretty major changes by drastically increasing the exemptions and the income levels where you can no longer claim the exemption, resulting in a major drop in how many people will get hit with AMT.
That said, the TCJA will phase out eventually, so we’ll go right back to where we started in a few years, unless Congress manages to pass another sweeping tax bill (which, with today’s political dynamics, feels like a daunting challenge).
AMT and the giant ISO Exercise
This all ends up relating back to startup equity through the wonderful Incentive Stock Option (ISO). You’ll recall that ISOs are a special type of stock option granted to employees (and can only be granted to employees) as a form of compensation. Like all stock options, they are granted with a strike price that the employee has to pay to exercise the option (once it has vested), to receive a share of stock. On the grant date, the strike price is the same as the stock’s fair market value, which, for private companies, is determined by the company’s most recent 409A valuation.
When you exercise a stock option, the IRS looks at the current fair market value of the stock, and they look at what you paid for the stock, and they interpret the difference as income (or loss, I guess, but if you’re exercising underwater options, you probably need to review some of my earlier articles). Generally, in subsequent fundraising rounds, the 409A valuation of a company will go up (not always, if you read my last article, but up and to the right is generally where companies are aiming). So when employees exercise their options after the company has taken more funding, there will typically be net income.
What makes ISOs special is that when they are exercised, the IRS doesn’t just tax you on the net income. The comparison to make is to the NSO (Non-qualified Stock Option), for which the income is taxed at your normal income rate (this can make NSOs extraordinarily expensive to exercise if they’ve appreciated in value). However, the income from the ISO exercise is one of the triggers for being required to calculate AMT liability.
Assuming you don’t sell the share you receive in the same tax year (which would realize the entire gain as short-term income), you may end up having to pay AMT. The keyword, again, is may. If your AMT liability is lower than your normal income tax liability, you don’t pay AMT.
Quirks of AMT and how to optimize your exercises
What I personally find really interesting about AMT is the funny reality that the more W2 income you make, the less likely you are to actually get hit with AMT, and the less W2 income you make, the more impactful AMT will be on your final tax bill. To illustrate the point, let’s consider a situation where you’re exercising options that result in a $275K gain by the IRS’s calculations (this scenario is entirely arbitrary, but the numbers made my chart pretty, so those are the numbers you get):
The major thing to recognize is that normal income tax rates are marginal rates that increase as your W2 income increases, which means they grow at a faster rate than your AMT liability will grow, since AMT liability stays at a fixed rate. If you file as a single taxpayer, you’ll pay AMT until you cross about $325K in income, and then pay regular income until your AMT exemption phases out enough to overcome your normal income tax, which happens around $625K of income. Again, these are toy numbers, so really just useful for illustrating the sweet spots of avoiding AMT.
In the case of wanting to optimize the amount of exercised options to avoid having to pay AMT, we can calculate break-even points based on the amount of W2 income, as well:
What I find particularly interesting about AMT is that you can reduce the amount of AMT that you’re subjected to by making more money. Because your AMT liability needs to be greater than your normal income tax liability in order to pay AMT, the more normal income you make, the less likely it is that your AMT will exceed it. In the chart above, you can see the breakeven point rise as your normal income grows, and peaks when the AMT exemption starts to phase out. So in a year where you expect to have a big AMT exposure due to a large exercise of options, you can actually reduce your AMT liability by doing things like rebalancing stock portfolios that have gains, or performing Roth conversions on IRAs. Obviously, there’s really only a benefit if you already planned on making those changes, but it provides an opportunistic point in time to get some of those things done.
Reality is much more complicated
The scenarios above are extremely over-simplified, and you definitely shouldn’t use these charts for tax planning, but hopefully it gives you a sense for how these dynamics work. For doing actual tax planning around AMT, please please please talk to an accountant.
In reality, there are a lot of different factors that can influence where your AMT liability falls compared to your normal income tax, beyond ISO exercise-and-hold situations. Another very common situation for startup employees is long-term capital gains. For example, having a large capital gains windfall (say, if your company IPOs) can also trigger AMT, because the capital gains rate is 15 or 20%, depending on your income level, which is less than the AMT flat tax. Capital gains don’t receive preferential treatment under AMT, so your AMT liability will end up higher than your normal income tax if you bring in a significant amount of long-term capital gains in a year.
Silver linings: AMT Credits
In a worst case scenario, a big exercise leads to a big AMT bill, but fortunately, that additional tax that you paid may be recoverable! Certain AMT triggers, in particular, ISO exercise-and-hold, make you eligible for AMT credits. If, in one year, you pay $10,000 in AMT due to ISO exercises, you’ll have $10,000 in AMT credits to use in future years. The next year that your normal income tax exceeds your AMT liability, you have the option of redeeming the AMT credits and paying the lesser of the two liabilities. So, if in year 2, your normal tax bill is $20,000, and your AMT liability is $17,500, you can claim $2,500 of the AMT credits, and only pay $17,500, and you’ll have $7,500 in AMT credits left to carry forward into future tax years. As such, it can take years to get those credits back, but as long as you’re not consistently paying AMT year after year, you’ll get there.
My own situation
As I mentioned at the start of this article, in the current market climate, I’m really trying to manage my exercises so I don’t pay any AMT, but exercise my vested shares as aggressively as I can. Effectively, I’m looking for that break-even point where my AMT liability matches my normal income tax. Actually going through that exercise is pretty complex, though, since my family’s income is heavily commission-driven, and our W2s are not consistent from year-to-year, not to mention the added complexity from investment returns. If you want to do this yourself, this is definitely something to consult with an accountant on, and please, don’t use any of this for tax planning. I’m not an accountant, I just play one on TV.