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By Eaton Vance Advisor Institute

IRS instruction booklets are notoriously eye-glazing and mind-numbing, and the IRS Form 6251 booklet for estimating alternative minimum tax (AMT) is no exception. In layman's terms, AMT adds back certain deductions to make sure wealthy taxpayers cannot reduce their taxable income too much.

After-Tax Advisors have a fiduciary responsibility to give AMT some thought and provide clients with information that might lead to better tax outcomes. Here are two important things to know and communicate with clients who have incentive stock options (ISOs):

  1. When ISOs vest, the exercise of these options could result in AMT. The bargain element for any ISOs exercised during the year — the total discount received when options are exercised to buy stock at a below-market price — gets added back to AMT income (along with deductions). This amount can be considerable, even though a client still holding the shares hasn't received any cash. Clients with multiple tranches of ISOs — or even a single large tranche — may want to discuss with their tax professionals a possible strategy of spreading the exercise of ISOs over several years to help avoid triggering AMT in any one year.
  2. A client exercising ISOs early in the year has "options" (pun intended). Buried in the instructions for IRS Form 6251, line 2i: "If you acquired stock by exercising an ISO and you disposed of that stock in the same year, the tax treatment under the regular tax and the AMT is the same, and no adjustment is required." Clients should discuss the two possible scenarios with their tax professionals:
    • If the stock price stays the same or rises over the course of the year, clients might consider keeping the shares and paying AMT this year so they can realize a long-term capital gain in the future and potentially an AMT credit when they sell the shares.
    • If, on the other hand, the stock declines significantly before year-end, clients may choose to sell the shares and eliminate the prospect of AMT, resulting in a short-term capital gain or loss on the shares sold, which may be preferable to AMT.

Be sure to remind clients to discuss any vested ISOs with their tax professionals. Due to their unique tax treatment, vested ISOs may be candidates for early exercise — early in the calendar year to preserve flexibility and early in their life spans (staged over several years) to reduce the likelihood of triggering AMT in any one year.

Bottom line: Now is the time for After-Tax Advisors to provide their clients with valuable insights on ISOs and AMT.