What Is the Alternative Minimum Tax (AMT)?
The Alternative Minimum Tax (AMT) is a federal tax system that exists separately and parallel to the regular income tax system. Taxpayers who earn above a certain income threshold must calculate their taxes twice—once with the regular method and once with the AMT method—and pay the total federal tax liability indicated by the higher of the two calculations.
This raises a rather obvious question: Why do we need a whole other tax system, lurking in the shadows of the regular tax system like some vaguely menacing figure? Aren’t taxes confusing enough as it is? It’s true that the AMT doesn’t inspire fuzzy feelings among taxpayers who must calculate it and, potentially, pay it. But it does exist for a reason. The AMT can be thought of essentially as a “tax floor,” ensuring that high-income taxpayers pay at least a minimum amount in taxes each year.
In this guide, we’ll cover the basics of the AMT, from how it works to who has to pay it. We’ll also review how exercising qualified employee stock options can trigger the AMT.
- What is the Alternative Minimum Tax (AMT?)
- How does the Alternative Minimum Tax work?
- Understanding the AMT exemption
- What situations trigger the AMT?
- The AMT and exercising incentive stock options (ISOs)
- Ready for the next step in your equity journey?
What is the Alternative Minimum Tax (AMT)?
The Alternative Minimum Tax can be a hard concept to wrap one’s head around, so let’s start with the basics.
Under federal tax law, wealthy taxpayers can take advantage of certain benefits to significantly reduce their regular taxable income (and, thus, their regular tax liability). The AMT sets a limit, or floor, on those benefits to ensure that every taxpayer at least pays a minimum amount of taxes.
It does this by employing a different set of rules to determine what counts as taxable income. These rules limit certain deductions and credits that could otherwise be used to reduce taxable income under regular tax rules. Certain taxpayers who earn adjusted gross income above the AMT exemption in a given year must calculate their taxes according to both sets of rules on their tax returns and pay the higher amount to the IRS.
We’ll get to AMT exemption amounts and how Alternative Minimum Taxable Income (AMTI) is calculated in a moment. First, let’s explore some of the history behind the AMT to learn how we got here.
A brief history of the AMT
The history of the AMT dates back to 1969, when U.S. Treasury Secretary Joseph Barr caused a national outcry by testifying that 155 wealthy individuals essentially paid zero income tax. To staunch the rising tide of public anger caused by this revelation, Congress passed an “add-on” minimum tax intended to capture income that wasn’t taxed (or taxed at very low rates) under regular income tax rules. This add-on tax was eventually folded into the Alternative Minimum Tax enacted in 1979, and we finally had the basis for what we know as the AMT today.
Though the AMT was originally conceived as a tax on wealthy folks who rather obnoxiously weren’t paying a dime in income taxes, it has evolved since. In fact, one of the reasons the AMT tends to elicit groans among non-billionaires is that it has historically required some middle- and upper-middle class households (including those of some startup employees) to pay an amount of tax that’s higher than their regular tax liability. To account for the effects of inflation, Congress continued passing “patches” to the AMT each tax year until finally passing the American Taxpayer Relief Act of 2012. This tax bill automatically adjusted AMT for inflation and allowed for certain tax credits.
Another major update to the AMT came with the Tax Cuts and Jobs Act (TCJA) of 2017. Among other changes, the TCJA increased the AMT exemption amount as well as the income level at which the AMT exemption begins to phase out. These changes will expire after 2025 without additional action from Congress, though they were significant enough to drastically reduce the number of taxpayers subject to the AMT from 4–5 million down to about 200,000.
How does the Alternative Minimum Tax work?
If you’re familiar with how the regular federal income tax rate works, that’s great—but you should know that the Alternative Minimum Tax is a pretty different animal. For one, the AMT relies on a different definition of “taxable income,” which the IRS calls Alternative Minimum Taxable Income (AMTI).
What is Alternative Minimum Taxable Income (AMTI)?
AMTI differs from regular tax income in several key ways. It does not include the standard deduction, nor does it include certain itemized deductions you might be accustomed to taking. Some commonly used itemized deductions that are not included in the calculation for AMTI include deductions for state taxes and local taxes (i.e. personal property taxes), employee business and medical expenses, and personal expenses, among others.
It can be a bit complicated to calculate your AMTI all on your own. IRS Form 6251 has info on all the specific tax breaks you can’t use to calculate AMTI. You can also rely on good tax software to help with the calculation, though we generally recommend consulting with a tax advisor to help determine your AMTI if you’re in doubt.
Understanding the AMT exemption
We’ve already mentioned that not every filer will have to pay the AMT. But what actually determines whether you pay the AMT or regular income tax in a given tax year?
Each year, the IRS sets an annual AMT exemption amount, and any incomes above this amount “trigger” the AMT. If your income is greater than the AMT exemption, you’ll need to calculate your taxes twice—the first time using regular income tax rules, and the second time using the AMT rules. If the taxes you owe using the AMT rules are higher, you’ll have to pay AMT.
Another important thing to understand about the AMT exemption is that it phases out and eventually disappears at a certain level of income. This is typically a very high level of income, which means that most people don’t have to worry about it. But just because you don’t make a salary north of $500,000 doesn’t mean you’re safe. Certain one-time events, such as exercising stock options or realizing big capital gains, can rocket your income past the phase-out threshold for a given year.
Now that we’re familiar with the AMT exemption, let’s look at the amounts for 2021 and 2022.
What are the AMT exemption amounts for 2021 and 2022?
The following AMT exemption amounts apply for the 2021 and 2022 tax year. (Keep in mind that taxes for 2021 are filed in 2022 and taxes for 2022 are filed in 2023.) If your income is above the exemption amount for your relevant taxpayer status, you may need to pay AMT.
What are the AMT exemption phase-out thresholds for 2021 and 2022?
As noted above, the AMT exemption phase-out thresholds were dramatically increased by the Tax Cuts and Jobs Act (TCJA) of 2017. Once your income reaches the AMT threshold for your relevant taxpayer status, the exemption begins to phase out at 25 cents per dollar.
What are the AMT tax rates for 2021 and 2022?
There are two AMT tax rates—26% and 28%. Which rate applies in a particular situation depends on how high your alternative minimum taxable income (AMTI) is. The 28% tax rate applies to excess income at the following levels for 2021 and 2022:
- In 2021, the 28% tax rate applies to AMTI in excess of $199,900 (or $99,950 for married couples filing separately)
- In 2022, the 28% tax rate applies to AMTI in excess of $206,100 (or $103,050 for married couples filing separately)
AMTI below those levels will be taxed at a rate of 26%. To keep up to date with the most current AMT tax brackets, you can reference the instructions for IRS Form 6251 for the tax year in question.
What situations trigger the AMT?
There are a few situations that may trigger AMT liability. Some of these can potentially be avoided with proper planning; others not so much.
One rather obvious situation that may trigger the AMT is called “being very rich.” All jokes aside, if your household income surpasses the phase-out threshold for a given tax year, the AMT may apply. This is especially true if you typically rely on a ton of itemized deductions, which can’t be calculated into your AMTI.
Even if your typical salary and income aren’t particularly high, you may still trigger the AMT if you realize big capital gains. This could mean selling a large amount of stock equity or it could mean selling a large and valuable asset, such as real estate. Though long-term capital gains are taxed similarly under regular income tax rules and AMT rules, you may lose some state and local tax deductions you would otherwise be able to claim if you’re required to pay AMT.
A third situation is especially relevant for our purposes here at Pulley, and it may be why you’re here in the first place. Exercising incentive stock options (ISOs) can trigger the AMT, even if you don’t sell the stock in the same year you exercise your options. Let’s take a closer look at how this works.
The AMT and exercising incentive stock options (ISOs)
A lot of people don’t even think about the AMT until the time comes to exercise their employee stock options. But this event can cause significant stress come tax time, thanks to a quirk in how the AMT is calculated.
As you may recall from our guide to how stock options are taxed, ISOs qualify for favorable tax treatment under regular income tax rules if they meet certain criteria. Assuming these criteria are met, the difference between the exercise price and the stock’s fair market value at the time of exercise is not subject to ordinary income tax.
Ah, but it may be subject to AMT. The difference between the exercise price and the stock’s fair market value at the time of exercise qualifies as an adjustment for the purposes of calculating AMT. This means that, even if you do not sell the shares you get from exercising your options, you will still be taxed on the profit you hypothetically would have made by doing so. And this “invisible” profit can be quite enormous if you exercised at a price well below the stock’s fair market value.
Can I avoid the AMT when I exercise my ISOs?
Well, it depends. You may be able to avoid the AMT if you decide to sell your exercised ISOs within the same tax year.
For example, say you exercise your ISOs at $10 per share when the stock’s fair market value is $50 per share. You monitor the stock’s performance over the course of the next few months and decide to sell your shares when it dips to $35 per share. You would then be subject to ordinary income tax on $25 per share (subtract your exercise price of $10 from the $35 price you sold the stock for) and avoid a potentially painful AMT adjustment.
Of course, you may not always be able to avoid triggering the AMT when exercising stock options, and in some cases it may be best to sell only a portion of the stock to help cover the taxes you may owe. This is where a trusted tax professional and a healthy dose of perspective can come in handy, helping you to stay excited about your windfall (as opposed to being bummed out about the taxes you may owe).
Ready for the next step in your equity journey?
It seems safe to say that the AMT is not anybody’s favorite topic, but we hope you learned something useful nonetheless. Understanding how to navigate the AMT and what may trigger it can be extremely helpful, especially if this is your first rodeo.
While we’re on the topic of taxes and equity, it’s important to note that different types of equity are taxed differently. If you want to read more about how taxes work for different equity types, check out our guides to stock options vs. RSUs, RSAs vs. RSUs, and phantom stock plans.
Still interested in learning more? Set up a call with one of our equity experts today.