AMT drag is the inverse of tax deferral.

Poorly conceived multi-year ISO plans have a common feature: AMT drag.

AMT earns you the right for long-term capital gains treatment on stock options. You pay AMT as a deposit and (ideally) get it back as a tax credit against LTCG when you sell the underlying option share.

The federal long-term capital gains rate for our clients is 20%. AMT is ~28%.

A question: If you pay 20% LTCG when you sell ISO shares, but receive only one-third of the AMT you paid at 28% back (7%), what is your tax rate? Answer: 20% plus 21% equals 41% on what you hoped to achieve long-term capital gains rates on.

A follow-up question: what is the highest tax rate on ordinary income and short-term capital gain? Answer: 37%.

Another question: Is it conceivable that a well-intentioned exercise-and-hold plan can be inferior to a simple exercise-and-sell? Answer: Unfortunately, yes!

When taxes are deferred, funds that would otherwise flow to the government are re-invested. Those funds earn an income stream. Over a long enough time, or with sufficient returns, that income stream can exceed the tax that would be owed initially.

In section 1031 exchanges – swapping investment real estate in a tax-free transaction – this deferral mechanism is at play. The same is true for investments in a Qualified Opportunity Zone, where capital gain is re-invested without first being reduced by tax.

The inverse to tax deferral is tax drag – creating a tax obligation that you’re waiting to recover.

Avoid AMT drag by adopting a thoughtful multi-year plan for your ISOs. The plan shouldn’t be needlessly rigid, and can remain flexible, but must be structured to mitigate the impact of AMT drag.