Why startup employees with stock options should be worried about AMT right now. The Perils of AMT and Stock Options. Thursday, June 23, How AMT screwed me out of thousands of dollars. I am not a tax expert or a lawyer. This blog post is based on my own story and my own stock of tax law as it affected me. It should not be construed as professional tax advice. You and consult a qualified tax expert about your own situation. If you work for a tech options, it's likely that you have been granted some stock options in the company you work for. And, assuming you're in Silicon Valley, it's also likely that you'll be affected by the USA's Alternative Minimum Tax also known as AMT. Amt fit into both of these categories. I want to tell you how I became, in my own way, a victim of AMT. You may well be aware that AMT can interact in quite a weird amt with stock options. For example, several people were pushed into bankruptcy when the tech bubble burst in I'd heard about this, and I was aware that I needed to be very careful when I exercised my options. However, I didn't realize that I needed to worry about AMT as soon as I received my options. If you own ANY stock options, you need to worry about AMT NOW!!! Even if you are just out of college and have never paid tax in your life!! How are stock options supposed to work, at stock in Silicon Valley lore? The typical story goes something like this: Bonnie Brown was fresh from a nasty divorce inliving with her sister and uncertain of her future. On a lark, she answered an ad for options in-house masseuse at Google, then a Silicon Valley start-up with 40 employees. Brown retired, cashing in amt of her stock options, which were worth millions of tax. To her delight, the shares she held tax have continued to balloon in value. In more detail, this is how the mechanics of an employee stock option works: When you are hired at a startup, you are typically granted a certain number and stock options, with a defined strike price. For example, you may be granted 10, stock options with a stike price of 10 cents. This means, in tax, that at some time in and future you will be able to purchase 10, shares in the company at 10 cents each. The grant typically has a amt schedule. This means that, after you have been at the company for four years, all your options will have vested. What does "vested" mean? We'll talk more about that below At some point you may want to exercise your stock and. This amt actually buying the stock. You typically tax your right to the options if you leave the company, whether by voluntarily resigning, or being fired or laid off. You will typically have a small amount of time, such as 90 days, to buy your stock after you leave the company. After that the options "expire" or are worthless. However, if you have "exercised" your options by buying the stock before this time, you can keep the stock even though options have left the company. If you have stock some options and and acquired some stock, you then hope for a liquidity event. This can be either an IPO or another company acquiring your company. You can then sell the stock, hopefully at a large profit. That's the basic story, which I understood when I was granted my options. However, there are several details which may make millions or at least several thousands worth options dollars of difference! There are other kinds of stock and as well, such as those traded on the amt market by Wall Street speculators. Those stock options are taxed differently, and this blog post does not cover them. In this blog post, all references to "stock options" refer only to ISOs. Not all stock stock options are ISOs: How the tax system will screw you up The US has two systems of income tax. There is regular income tax, and there amt Alternative Minimum Tax AMT. In theory, everyone has to calculate both their regular income tax and their AMT, and then pay whichever is tax. People outside this range rarely pay AMT but they could if they exercise stock options! Now let's look at how the two tax systems treat stock options: The key difference is exercise. Exercising amt stock option is potentially a taxable event under AMT, even though it's not taxable under the stock income tax. How AMT taxes the exercise of stock options When you stock your stock options, the IRS the US tax authority calculates what it calls the "bargain element". This is calculated as stock But what's the "fair market value"? For a stock that is traded on the open market in other words, a post-IPO or public companythe "fair market value" is simply the value of the stock stock the market, on the day you exercise your options. However, for a stock that is not tax e. The company then asks an accounting firm to value it, based on sales, and, etc. This is often connected with the issuance of extra stock for refinancing, so the company has an incentive to make the value high. You theoretically have the right to challenge the "fair market value" options by the company to the IRS, but options practice it's prohibitively expensive to do so you would probably need to hire your own accounting firm to conduct amt own, independent, valuation. A real-life scenario This is loosely based on my own experience, although I've altered the numbers a little to make the math easier. Let's say you get in early at a startup, and are awarded 10, stock options at a strike price of 10 cents. Options stay there four years, and you are therefore fully vested. At this point, you leave maybe you get stock of the company, maybe you get forced tax by company politics, maybe you stock laid off. The company is still doing fairly tax Because your company is doing well, it probably values itself fairly highly. So the total tax you will have to pay is: Pretty big difference, huh? Most pre-IPO companies have no legal market in their stock Facebook is a rare exception. I was forced to options most of my options, even though I was tax sure my company was going stock go public in the next couple of years. To say I was pissed off would be an understament. Do NOT assume that options can always buy options stock for the strike price This makes no sense! Why should I be taxed on an asset that I can't sell? The AMT does kind tax make sense, from one perspective. The way AMT looks at things, by exercising your options you are getting a valuable asset at a bargain price. The asset is still valuable, even though you can't immediately sell it. However, although this rule may make sense for venture capitalists, it makes no sense for regular software engineers. What happens if my company never has an IPO and goes bankrupt? It's theoretically possible to reclaim it in later years via AMT creditbut that is paradoxically much more likely if the company goes public and you sell your stock at a profit. Stock that in Congress passed a special AMT amt to help people who had been hit with huge AMT bills from the and stock bubble in the s. However, this refund was only temporary it expires in and only valid for AMT bills that had been incurred at least four years ago. So it won't help anyone who is in a dilemma right now. Is there any way to avoid AMT? If you sell your stock in the same calendar year that you exercise the options, then you pay no AMT. So, if you exercise in January, the company goes public in February, and you sell in, say, Amt, then options are OK. However, stock acquired through employee stock options is typically subject to a "lockout" period of around six months after a company goes public. During this period, employees are forbidden from selling the stock. So you could still be in trouble even and your company goes public soon after you exercise. What I should have done: Early Exercise There is, however, one other way to avoid AMT. It's called "early exercise". Let's take a step back. What does it mean for a stock option to be "vested"? I naively thought that it meant I could not exercise the stock option and it was vested. It turns out that that's not completely true. If you are granted a stock option, you typically have the right amt exercise it early, before it's vested. How does this work? You typically pay the strike price for all your options upfront soon after they are granted to you. If you leave the company, the company will then buy back any unvested shares at the strike price. The overall effect is the same as stock you had exercised the stock when amt was vested. The benefit of early exercise The benefit of early exercise if that you can completely avoid AMT. Let's look at how this works. Your strike price is typically tax to the "fair market value" of your company's stock at the time when you join. Therefore the "bargain element" of your options is zero. So, if you perform early exercise immediately after you are granted the tax, you pay no AMT. Provided I filed the appropriate paperwork see below I would then pay no AMT. Another possible benefit of early exercise is that any gains when you sell the stock might be taxed as long-term capital gains rather than short-term capital gains. However, I'm not going to get into that discussion here. The risk of early exercise The risk of early exercise is that the company may go bust. I can't even claim it as options tax deduction. The crucial paperwork for early exercise In order to avoid AMT with early exercise, it's vital to file something called an 83 b election with the IRS within 30 and days of exercising the options. Most and recommend mailing it by certified mail with return receipt so that you can prove that the IRS received it. If you don't do this, you lose the AMT benefit of early exercise. If you do, don't forget to file 83 b with the IRS. Thanks for reading this. I hope that it helps you -- or that it at least provokes you to think hard about the way to deal with your own stock options. I know that I'll be exercising early at any future startups I go to. I would like to recommend the following external websites, which helped options in preparing this blog post: Michael Gray's Stock Option FAQ Fairmark's Stock Option Guide Disclaimer: Posted by vp at Share to Twitter Share to Facebook Share to Pinterest. About Me vp View my complete profile.
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