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ISOs: AMT Advanced
Editor's Note: The tax-code provision for refundable AMT credits was not extended by the American Taxpayer Relief Act of 2012. Therefore, the refundable AMT credit became unavailable after 2012. Unless the rules are extended, AMT credits created in 2009 or later are not eligible for the refundable AMT credit.
On this topic, myStockOptions.com is delighted to have the following contribution by Kaye Thomas, author of the book Consider Your Options, available from Fairmark Press. His two articles (see also the first article) give complete coverage of the refundable AMT credit, which provides a way for many people to use more of the AMT credit than under the regular rules. For an update by Kaye Thomas on the AMT credit after ATRA, see Last Call For Refundable AMT Credit at Fairmark.com.
Preliminary: Abatement Of Unpaid AMT
The tech stock collapse that began in 2000 left some people with AMT liabilities far beyond their ability to pay. Some of them had to deal with IRS collection efforts over a number of years. The original version of the refundable AMT credit did little to remedy this situation. Someone who owed $1,000,000 to the IRS might qualify for a credit of $200,000 or less. The IRS would apply that credit against the amount owed and continue trying to collect the remaining amount. The new version does away with that problem.
The law says that if, as of October 3, 2008, you owed AMT as a result of exercising an incentive stock option (ISO) in 2007 or any prior year, the tax is abated. That means you don't have to pay it. The tax is wiped off the slate. You don't have to pay interest or penalties relating to that unpaid tax, either. It's as if you never owed it.
This relief doesn't extend to AMT you might owe for any reason other than exercising an incentive stock option. Even if your unpaid AMT relates to a "timing adjustment" (the kind of adjustment that allows you to claim AMT credit later), tax abatement doesn't apply unless it was the specific timing adjustment that applies when you exercise an ISO and hold the stock after the end of the year of exercise.
Naturally, if you escaped having to pay AMT as a result of this provision, you can't claim a credit for this unpaid tax.
It isn't at all clear why Congress extended this provision to unpaid tax from 2007. People who paid AMT for that year aren't allowed to claim a refund. They have to wait until they're able to claim the AMT credit, something that may not occur for several years. Meanwhile, someone who didn't pay the tax got off scot-free, regardless of whether their nonpayment was due to hardship or forgetfulness or even outright cheating. We've seen some bitter complaints about this from people who paid their tax in 2007 or other recent years.
Step 1: Available AMT Credit
The first step in determining the amount of AMT credit you can claim is to determine the amount of available AMT credit. This is your starting point under the normal rule for claiming AMT credit, and also under the refundable AMT credit, which is available to certain people who have long-term unused minimum tax credit.
Alert: This section describes how to determine the amount of available AMT credit, but this is not necessarily the amount of credit you'll actually claim. This is just one step in the process of determining how much credit you can claim under either the normal AMT credit or the refundable AMT credit.
Two Kinds Of Adjustments
Broadly speaking, when you pay AMT it is because of certain items that receive different treatment under the AMT rules. For example, if you claim itemized deductions you're allowed to deduct state and local taxes. This deduction isn't allowed under the AMT rules, so a deduction for this item may cause you to pay AMT.
The AMT rules don't always completely disallow a tax benefit. Sometimes they change the treatment so that income reported in one year under the regular tax rules is reported in a different year under the AMT rules. For example, the profit from exercising an incentive stock option may be taxed in the year you exercise the option under the AMT rules, but in a different year when you sell the stock under the regular income tax rules. Items that can end up in different years under the AMT rules are called timing items.
Without the AMT credit, the income from timing items could end up being taxed twice: first under the AMT, and in a later year under the regular tax rules. The AMT credit is designed to prevent this result, so it is allowed only for the part of your AMT payment attributable to timing items. Any portion of your AMT payment that relates to other items (such as the itemized deduction for state and local taxes) is not eligible for later recovery as AMT credit.
How The Calculation Works
In essence, the AMT functions as a parallel tax system in which we determine how much tax you would have paid if a different set of rules applied to your income. When we determine how much of your AMT is eligible to be used as a credit in later years, we actually do another parallel calculation under a third set of rules: the AMT rules without the timing items. This tells us how much AMT you would have paid without the timing items.
We compare the outcome of this calculation with the actual amount of AMT paid for the year in question. If the actual AMT is greater than the calculation without the timing items, we know the additional amount is due to the timing items.
In practice, this calculation appears on Form 8801 for the year after you paid AMT. The IRS hasn't taken my suggestion to calculate this number in the same year you pay AMT. Calculating it on the following year's form can create problems for people who change their filing status. For example, two unmarried individuals may both pay AMT in one year and then file jointly the following year. Form 8801 will not provide the correct result in this situation.
Apart from this glitch, and the mind-boggling complexity of the overall process, this method of calculation is generally favorable to the taxpayer. Calculating the available credit this way maximizes the amount that's considered attributable to timing adjustments, and therefore eligible for later recovery as AMT credit.
Example: You pay $8,000 of AMT for a year in which you have a $20,000 adjustment from exercising an incentive stock option and a total of $20,000 in other adjustments. It might seem logical that only half of the $8,000 payment would qualify for later use as AMT credit. However, the calculation described above shows that you would have paid $2,400 in AMT without the timing item from the option. That means the amount available to be claimed as AMT credit in later years will include $5,600 from this year.
Available AMT credit that isn't used or otherwise absorbed will carry over to the following year. In effect, your available AMT credit for any given year is the amount created in the preceding year (as a result of paying AMT that year) plus any amount carried over from earlier years.
Using This Number
You can claim available AMT credit under the normal rules to the extent your regular income tax exceeds the tax calculated under the AMT rules. To claim the refundable AMT credit you need to continue with a more complicated calculation, where the next step is to determine how much of your available AMT credit qualifies as long-term unused minimum tax credit.
Step 2: Long-Term Unused Minimum Tax Credit
One of the requirements to use the refundable AMT credit is to have available AMT credit that is old enough to qualify as long-term unused minimum tax credit. Applying this rule is the second step in the process of determining how much refundable credit you can claim.
Long-Term Unused Minimum Tax Credit
You can't use the refundable AMT credit to recover AMT you paid last year or the year before. It allows recovery only if you have unrecovered credit from years that are more than three years earlier. The first year this provision applied was 2007 (returns filed in 2008), and for that year you were potentially able to use this rule to recover AMT paid for any year up to and including 2003 (returns filed in 2004). If you have unused credit for more recent years, you'll have to either recover it under the normal rule or wait until the credit ages enough to be recoverable under this rule.
First In, First Out
There are people who pay AMT in some years and recover AMT credit in other years. Some people intentionally create this situation, believing it produces a more efficient use of the AMT credit. (I've seen this strategy recommended by experts, but generally it's a poor strategy. As Fermat once said, the proof is too long for me to provide it here.) In any event, an alternation between paying AMT and using the credit raises a question about whether the remaining credit pertains to the older years or the more recent ones. The answer is supplied by the first-in, first-out rule, or FIFO. This rule says that whenever you use AMT credit, you're treated as using the oldest credit.
On its face this seems like a plausible enough rule, but it can have unexpected consequences.
Example: You paid $100,000 AMT on the exercise of an ISO in 2000 but didn't recover any of this amount as credit after the stock price collapsed. In 2006 you again paid $100,000 AMT on exercise of an ISO and this time you had better luck: you recovered the full amount when you sold the stock for a profit in 2007. You still have $100,000 of unused AMT credit because of what happened in 2000.
Your ability to claim AMT credit in 2007 related directly to the sale of stock that produced AMT liability in 2006, so it seems fair that you should be able to treat the remaining amount as long-term unused minimum tax credit. The law provides otherwise. You're treated as having used the credit from 2000, and you're left with credit from 2006, which won't qualify as long-term unused minimum tax credit until 2010.
Using This Number
If you have long-term unused minimum tax credit, the next step is to use this number in determining the tentative refundable credit.
Step 3: Tentative Refundable Credit
Once you've determined your long-term unused minimum tax credit you can use that number to determine the tentative refundable credit. This is the amount of refundable AMT credit you're allowed to claim, subject to coordination with the regular AMT credit.
Determining The Tentative Refundable Credit
Your refundable credit base amount can never be larger than your long-term unused minimum tax credit. Subject to that restriction, it's the largest of these numbers:
In addition, if you paid interest or penalties as a result of owing AMT on the exercise of an incentive stock option for any year before 2008, your tentative refundable credit is increased by half that amount for the years 2009 and 2010, allowing you to recover that amount over a period of two years.
This is one of the provisions that has caused heartburn for people who paid their tax on time. Some of them took out second mortgages or incurred other costs to come up with the money to pay the tax, and there's no way for them to recover those costs. Yet people who didn't pay when the tax was due avoid paying even the relatively low interest rates that apply to unpaid income tax.
$5,000 Floor Eliminated
The version of the refundable credit that applied to 2007 allowed only 20% per year but with a $5,000 floor. Someone whose long-term unused minimum tax credit was $12,000, for example, would expect to recover $5,000 in 2007, another $5,000 in 2008, and the last $2,000 in 2009. The new version, for years 2008 and later, raises the percentage from 20% to 50%. It eliminates the $5,000 floor, but says you can claim the same amount as the previous year (without regard to the income phaseout). Because of this lookback, anyone who used the $5,000 floor on a 2007 tax return will get the benefit of that floor in subsequent years. In the example earlier in this paragraph, the schedule for recovering the credit will remain unchanged, even though $5,000 is more than 50% of the credit that remains unused in 2008.
There is one narrow group of taxpayers who lose out from the elimination of the $5,000 floor. Suppose you're claiming the refundable credit for the first time in 2008 because your unused credit wasn't old enough in 2007 to qualify for this benefit. You can claim only 50% of the credit in 2008, even if the result is that you claim less than $5,000 for the year. Under the old version of the rule you would have been able to claim at least $5,000 for 2008.
Using This Number
The phaseout rule that applied to higher-income taxpayers for 2007 has been repealed, so there's just one more step in determining your refundable credit: coordination with the regular AMT credit.
Editor's Note: If you need to calculate the credit for the tax year 2007, see Kaye's discussion of this on Fairmark.com.
Step 4: Coordination With Regular AMT Credit
The previous steps in this calculation yield a number the IRS calls the tentative refundable credit. This number is tentative in the sense that it will be reduced to the extent you're able to claim the regular AMT credit in the same year. If your regular AMT credit is larger than your tentative refundable credit, you won't receive any refundable credit at all. This means the total amount of AMT credit you can claim in a given year is equal to the regular AMT credit or the tentative refundable credit, whichever is larger. You aren't allowed to add them together.
Example: This year your regular income tax is $3,000 greater than your tax as calculated under the AMT rules, so you're allowed to claim $3,000 of AMT credit under the regular rule. Your tentative refundable credit is $7,000. In this situation, you'll claim a total of $7,000 in AMT credit for this year. You won't be allowed to add these amounts together and claim $10,000.
Regular Rule Recovers More Recent Tax
This rule will apply even in a situation where your ability to claim the regular AMT credit relates to AMT paid in more recent years. In the example above, you may have had $35,000 in long-term unused minimum tax credit and another $5,000 in available AMT credit from exercising an incentive stock option in the most recent year. Your recovery of $3,000 under the regular AMT credit results from a sale of the stock you acquired last year. It might seem fair to allow both credits in this situation, permitting you to recover the full amount of the long-term credit within five years. Unfortunately, the law treats the $3,000 that's available under the regular AMT credit as if it comes from the long-term unused minimum tax credit.
For technical reasons, refundable credits appear in a different place on your tax return than other credits. In the example above, you would report a regular AMT credit of $3,000 and a refundable AMT credit of $4,000. The total amount claimed is equal to the tentative refundable credit (the larger of the two amounts), but that total is split between two different lines of the return.
If your return shows a smaller refundable credit than you expected, check to see if this is because you're receiving part of your overall AMT credit for the year under the regular rule.
Using This Number
The key point about the final number in this calculation is that it is refundable. This means it can be used against regular income tax or against AMT, and you can receive a check from the IRS reflecting the full amount even if the result is a refund that exceeds the total amount of tax you paid for the year.
Kaye Thomas is author of Consider Your Options: Get The Most From Your Equity Compensation, a plain-language guide to handling stock options and other forms of equity compensation. Consider Your Options is available from Fairmark Press, a leading independent online publisher of tax guidance on a wide range of topics, including stock options, IRAs, capital gains, and college savings. This article was published solely for its content and quality. Neither the author nor his firm compensated us in exchange for its publication.