The alternative minimum tax and incentive stock options
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Exercising an incentive stock option (ISO) can trigger the Alternative Minimum Tax (AMT) [1, 5]. An option is a contract that gives you the right to buy or sell an asset at a set price within a specific period [3]. An ISO is a type of employee benefit that lets you buy company stock at a discount [5]. While you do not owe regular income tax when you exercise—which means buy—the shares, the difference between the stock's market value and your purchase price must be reported as income under the AMT rules [5].
The AMT is a separate tax system that ensures taxpayers who receive special tax treatments still pay a minimum tax amount [1]. This system adds specific tax preference items back into your taxable income to calculate your alternative minimum taxable income [1]. You then subtract an AMT exemption amount, which is based on your filing status, to find out if you owe the tax [4]. You must file Form 6251 to calculate and report your AMT liability [1, 5].
You can avoid the AMT adjustment on your stock options if you sell the shares in the same calendar year that you bought them [5]. If you keep the shares past the end of the calendar year in which you exercised them, you must report the price difference as an AMT adjustment [5]. When you eventually sell those shares, you will have two different cost bases, which are the values used to determine your taxable gain [5]. For regular income tax, your cost basis is the price you originally paid to buy the shares [5]. For the AMT, your cost basis is the market value of the stock on the day you exercised the option [5]. If you pay AMT because of your stock options, you may qualify for a minimum tax credit to reduce your tax bill in future years [1].
To determine how exercising your options will affect your tax liability, use Form 6251 to estimate your AMT before you buy the shares.