How Much ISO Bargain Element Triggers AMT? A Tax Planning Guide by Income and Filing Status

When investors begin learning about Incentive Stock Options (ISOs) and Alternative Minimum Tax (AMT), they often ask: "How much of a bargain element can I have before I am subject to AMT based on my tax filing position?"

In today’s educational video, I will walk you through various scenarios so you can understand what the bargain element might look like based on different income levels and tax filing statuses. Additionally, I will include net long-term capital gains in these scenarios because a follow-up question is: "Does increasing capital gains raise my tax rate?"

Net short-term capital gains are taxed at ordinary income tax rates and we are not going to include net short-term capital gains because that will increase our ordinary income. Net long-term capital gains are taxed at 0%, 15%, or 20%. Adding net long-term capital gains does not raise our ordinary income tax rate, but it can increase our capital gains tax rate. This is because net long-term capital gains are added on top of ordinary income. Ordinary income fills up the tax brackets first and is taxed at ordinary income tax rates. Net long-term capital gains fill the remaining space and are taxed at the capital gains tax rates. Remember, net long-term capital gains are taxed at graduated capital gains tax rates. When we have a large amount of capital gains, we can be subject to all three rates. I have clients whose annual capital gains are three times higher than their salary when they were working. We normally see these scenarios from ultra-high-net-worth families where wealth is transferred from one generation to another.

This article aims to answer the questions by examining various scenarios and providing insights into the relationship between the bargain element, capital gains, and AMT.

What is the bargain element?
The bargain element is the difference between the market price of a stock and the exercise price of an option when the option is exercised. This difference determines the taxable amount under AMT when exercising ISOs.

What is the alternative minimum tax (AMT)?
AMT is a parallel tax system designed to ensure that individuals and corporations pay at least a minimum amount of tax. It operates by adding certain tax preference items back into taxable income and applying a separate tax rate. One such preference item is the bargain element from ISOs.

To understand the max bargain element before AMT and federal tax liability, let's explore some scenarios based on different tax filing statuses and earned incomes.

Single Tax Filing Status
Earned Income: $100,000
Max Bargain Element before AMT: $38,936
Federal Tax Liability: $13,841

Earned Income: $250,000
Max Bargain Element before AMT: $39,603
Federal Tax Liability: $53,465

Earned Income: $500,000
Max Bargain Element before AMT: $103,261
Federal Tax Liability: $142,965

Earned Income: $1,000,000
Max Bargain Element before AMT: $169,422
Federal Tax Liability: $329,986

Let’s add long-term capital gains equal to our earned income to see what the max bargain element before AMT and federal tax liability are.

Single Tax Filing Status
Earned Income: $100,000
Long-term Capital Gains: $100,000
Max Bargain Element before AMT: $38,936
Federal Tax Liability: $28,841

Earned Income: $250,000
Long-term Capital Gains: $250,000
Max Bargain Element before AMT: $39,603
Federal Tax Liability: $100,465

Earned Income: $500,000
Long-term Capital Gains: $500,000
Max Bargain Element before AMT: $17,561
Federal Tax Liability: $260,290

Earned Income: $1,000,000
Long-term Capital Gains: $1,000,000
Max Bargain Element before AMT: $169,422
Federal Tax Liability: $567,986

Adding long-term capital gains can influence the max bargain element before triggering AMT. Why did the max before AMT increased, decreased, and then increased?
Here is the direct quote from a tax specialist I have a relationship with, “we should expect the "max before AMT" amount to change as other income elements to change. That's AMT only comes into play if/when the tentative minimum tax that's calculated on Line 9 of Form 6251 exceeds the standard tax obligation. When that happens, the difference between those two amounts is technically your amount of AMT. As your regular income increases (which is what would happen with higher wage amounts), so does your standard tax obligation. You can watch my educational video on Understanding the Relationship Between the Standard Tax Liability and the Tentative AMT Liability to learn more.

Let’s make the bargain element equal to our earned income to see what the max bargain element before AMT and federal tax liability are.

Single Tax Filing Status
Earned Income: $100,000
Bargain Element: $100,000
Max Bargain Element before AMT: $38,936
AMT Liability: $15,877
Federal Tax Liability: $29,718
If we take the total federal tax liability of $29,718 minus the AMT liability of $15,877 equals the federal tax liability without AMT liability is $13,841. The $13,841 is on the first scenario of this video.

Earned Income: $250,000
Bargain Element: $250,000
Max Bargain Element before AMT: $39,603
AMT Liability: $58,338
Federal Tax Liability: $111,802

Earned Income: $500,000
Bargain Element: $500,000
Max Bargain Element before AMT: $103,261
AMT Liability: $135,083
Federal Tax Liability: $278,048

Earned Income: $1,000,000
Bargain Element: $1,000,000
Max Bargain Element before AMT: $169,422
AMT Liability: $232,562
Federal Tax Liability: $562,548

As we can see, having a bargain of $0 to $1,000,000 doesn’t change the max bargain element before AMT because Max before AMT is the amount we can have before we are subject to AMT liability.

We are going to change from single tax filing status to married filing jointly tax filing status to all the previous scenarios so we can see what the max bargain element before AMT and federal tax liability are.

Married Filing Jointly Tax Filing Status
Earned Income: $100,000
Max Bargain Element before AMT: $64,194
Federal Tax Liability: $8,032

Earned Income: $250,000
Max Bargain Element before AMT: $33,598
Federal Tax Liability: $39,077

Earned Income: $500,000
Max Bargain Element before AMT: $28,591
Federal Tax Liability: $108,279

Earned Income: $1,000,000
Max Bargain Element before AMT: $168,921
Federal Tax Liability: $292,072

Let’s add long-term capital gains equal to our earned income to see what the max bargain element before AMT and federal tax liability are.

Married Filing Jointly Tax Filing Status
Earned Income: $100,000
Long-Term Capital Gains: $100,000
Max Bargain Element before AMT: $64,194
Federal Tax Liability: $19,545

Earned Income: $250,000
Long-Term Capital Gains: $250,000
Max Bargain Element before AMT: $33,598
Federal Tax Liability: $86,077

Earned Income: $500,000
Long-Term Capital Gains: $500,000
Max Bargain Element before AMT: $28,591
Federal Tax Liability: $221,632

Earned Income: $1,000,000
Long-Term Capital Gains: $1,000,000
Max Bargain Element before AMT: $35,621
Federal Tax Liability: $530,072

Let’s make the bargain element equal to our earned income to see what the max bargain element before AMT and federal tax liability are.

Married Filing Jointly Tax Filing Status
Earned Income: $100,000
Bargain Element: $100,000
Max Bargain Element before AMT: $64,194
AMT Liability: $9,310
Total Federal Tax Liability: $17,342

Earned Income: $250,000
Bargain Element: $250,000
Max Bargain Element before AMT: $33,598
AMT Liability: $58,947
Total Federal Tax Liability: $98,024

Earned Income: $500,000
Bargain Element: $500,000
Max Bargain Element before AMT: $28,591
AMT Liability: $131,995
Total Federal Tax Liability: $240,274

Earned Income: $1,000,000
Bargain Element: $1,000,000
Max Bargain Element before AMT: $168,921
AMT Liability: $270,027
Total Federal Tax Liability: $562,098

The relationship between the bargain element, AMT, and capital gains is intricate and varies significantly based on our tax filing status and income. By understanding these dynamics, investors can better navigate their tax liabilities when planning to exercise ISOs and selling the shares.

Please note that this material is for educational use only. Tax laws are written in pencil; they can always be rewritten. Tax laws are complex, there are exceptions to the rules, and it’s constantly changing so don’t do it alone. Be sure to talk to a qualified professional before making an informed decision. I hope you enjoyed this video and thank you for watching it. Until next time, this is Tan, your trusted advisor.

Wealth Perspectives

How Much ISO Bargain Element Triggers AMT? A Tax Planning Guide by Income and Filing Status

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