Has the New Tax Law Created an “Open Season” for Exercising Incentive Stock Options?
March 02, 2018
By Gregory Pospichel
Stock option compensation is a popular perk of working for a startup company. Most early-stage companies set aside a tranche of corporate shares to offer to employees in the form of stock options -- usually incentive stock options (ISOs). An employee is granted the option to purchase shares of the company stock at a price equal to the fair market value of the shares on the date of grant. These grants are typically subject to a four-year vesting schedule starting after year one, and monthly vesting thereafter. When the employee actually exercises the ISO, the difference between the current fair market value of the shares and the exercise price that the employee pays is referred to as the “spread.” No income is recognized for regular tax purposes on the spread, but the spread is includible in taxable income for alternative minimum tax (AMT) purposes. Thus, a taxpayer who is not subject to AMT in a given year would theoretically be able to exercise ISOs tax-free, while a taxpayer who is subject to AMT would incur a tax bill upon purchasing the shares.
Prior to the Tax Cuts and Jobs Act (TCJA), being subject to AMT was a common occurrence for startup employees in popular tech locales such as California, New York, and New Jersey due to those jurisdictions having high state income taxes and expensive real estate, and therefore high real estate taxes (state income taxes and home real estate taxes are a deduction for regular tax purposes, but are disallowed for AMT). Oftentimes, even if a taxpayer in one of these areas was not subject to AMT, they were “on the verge” of AMT, meaning that even a modest spread on an exercise of ISOs could subject them to the alternative minimum tax. Couple these factors with the trend of highly-valued startup companies delaying initial public offerings, and you end up with large amounts of employees finding themselves in a situation where they cannot realistically exercise. Imagine an employee who has vested stock options in a private company for shares that are worth millions of dollars, but the employee can’t afford to exercise the shares because of the astronomical tax bill that would follow thanks to AMT. The employee is essentially stuck at their employer because if they terminate employment, they typically forfeit the stock options if they don’t exercise them within 30 days.
While complete repeal of the alternative minimum tax was discussed, the final version of the Tax Cuts and Jobs Act retained the AMT for individuals. However, AMT is projected to not ensnare as many taxpayers as before due to a few key changes. First, the personal exemptions that taxpayers claimed for themselves and their dependents have been eliminated. The personal exemption was allowed against regular tax only, not against AMT. Second, the itemized deduction for taxes (state income taxes and real estate taxes combined) has been limited to $10,000. Recall that these taxes were also not allowed as a deduction for AMT. This means that for residents in the high state tax states, their AMT taxable income will generally only start off $10,000 higher than their regular taxable income, as opposed to tens or hundreds of thousands of dollars higher when there was no limit on itemized deductions for taxes. Third, the AMT exemption amounts were increased (the AMT exemption is an extra reduction of AMT income taxpayers receive, subject to phase-outs). Lastly, the phase-out levels for the AMT exemptions were also increased. The AMT exemption doesn’t begin to phase out until tentative alternative minimum taxable income is $500,000 for an individual, or $1 million for a married couple. These changes should mean that a lot fewer taxpayers are subject to AMT, and those taxpayers may find that they have more room available to exercise ISOs tax-free.
If a taxpayer still finds that they are subject to AMT even with these changes, there are still strategies to employ including straddling two tax years for exercises, bunching certain deductions or ordinary income, delaying or accelerating capital gains, and disqualifying dispositions.