ISOs, AMT and the MTC, Understanding What They All Really Mean

If you’re an individual with ISOs (Incentive Stock Options), you quickly learn that AMT (Alternative Minimum Tax) can become a very real consideration around exercising those options. Besides being introduced to a completely new tax, the associated MTC (Minimum Tax Credit) may be a further contributor to confusion you may be feeling. Now that we’ve gotten all the abbreviations out of the way, the following in an illustrative example to help you understand the interplay of ISOs, AMT, and the MTC.

Let’s set the table for a very simplified example. This hypothetical individual is single and works at a growing tech company receiving compensation of $200,000 a year. They get a modest 3% raise every year, and they contribute the maximum of $19,500 to their 401(k). The only other assets on their radar are the 5,000 ISOs they were granted, at a price of $5/share, when they started working at the company 3 years ago. The expiration date on these options isn’t for 10 years, and so they haven’t exercised any yet. The company makes a surprise announcement that they are going public, and after the IPO the shares are now trading at $45.

To our (fortunate) individual, they now have an account with ISOs showing a value of $225,000 (5,000 x $45) and many decisions to make. We’re going to set most of those decisions aside for this discussion and get right down to how the MTC plays into this picture.

Oversimplified Assumptions: The individual exercises all the options this year and holds the stock. To do this, they need to come up with $25,000 for the $5 exercise price. The difference between the current market value and the amount to exercise is known as the “bargain element”. This is the key to generating the ominous AMT. Even without selling the shares and getting an actual payday, this puts $200,000 onto the individual’s tax return as an AMT preference item, thereby ratcheting up their tax due.

The best way to think about AMT is that it’s a completely separate tax calculation from your normal one. If this calculation results in a higher amount due than the regular calculation, then it comes into play. Hence the “minimum” part.

In this very basic example, the individual normally would not have been subject to AMT. Prior to the Tax Cuts and Jobs Act of 2017, many more people (especially in states with high income tax rates) were subject to AMT. Without the ISOs the individual would have paid $34,808 of regular Federal Income tax. However, due to the option exercise, the AMT calculation results in a Tentative Minimum Tax (we don’t need to give that one an abbreviation) of $82,170.

Finally, the punchline. This difference between the regular calculation and AMT calculator creates the MTC. In this example, it is $47,362 ($80,170 minus $34,808). While the full $82,170 must be paid to the IRS by April 15th of the following year, it’s not entirely lost. The individual also gets an asset in the form of the MTC to use in future tax years.

The trick to recouping MTC in future years is to not be subject to AMT. The MTC is applied to the normal tax calculator to reduce it to the amount that would have been paid via the AMT calculation. If the regular tax calculation was equal to the AMT calculation, the MTC applied would be $0. In our example here, this individual would take 7 years to use up the entire credit.

Year	2020	2021	2022	2023	2024	2025	2026	2027
Regular Tax Calculation	$34,808	$36,728	$38,705	$40,742	$42,840	$45,001	$52,663	$55,027
Tentative Minimum Tax (AMT)	$82,170	$29,536	$31,143	$32,798	$34,502	$36,258	$48,136	$50,464
MTC Applied (Nonrefundable)	$0	$7,192	$7,562	$7,944	$8,338	$8,743	$4,527	$3,056
Federal Tax Due	$82,170	$29,536	$31,143	$32,798	$34,502	$36,258	$48,136	$50,464
MTC Remaining	$47,362	$40,170	$32,608	$24,664	$16,326	$7,583	$3,056	$0

Of course, this analysis ignores all the other factors at play. An obviously huge consideration is ultimately the selling of the shares and the realization of some form of capital gain. The analysis is incredibly sensitive to the stock price, other income, and liquidity needs. Further compounding the complexity of these factors is the uncertainty an election year brings, which could see drastic changes to the tax policy and related AMT calculations.

For these reasons, the complete ISOs analysis quickly becomes very complex and customized for the individual. Understanding how the MTC asset works is just one important first step to the decision making process. You should, of course, work closely with a financial advisor to consider all the aspects of your specific situation.

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Dann Ryan is a New York City-based CERTIFIED FINANCIAL PLANNER™ Practitioner & Managing Partner at Sincerus Advisory. Click here to schedule a time to speak with us.