Alternative Minimum Tax - Is This A Good Alternative For Startup Equity

Alternative Minimum Tax - Is This A Good Alternative For Startup Equity

As per The Income Tax Act, various deductions and exemptions have been making way for taxpayers in the high-income range to get away with paying zero tax or a very small amount of tax. This defeats the very purpose of imposing these taxes as well as these deductions, so to avoid this happening, a tax law was first introduced in 1969, popularly known as Alternative Minimum Tax, wherein the main objective was to make sure that people who have higher incomes( particularly higher than the average incomes as per those times) did not end up paying zero tax or a small amount of tax as compared to their huge income.

What are Alternative Minimum Tax and everything related to it?

Going by its very name, we can understand what this means. Alternative Minimum Tax is the minimum tax that a person has to pay if AMT is applicable. This is done by applying  the following procedure:

  • Calculating adjusted income by adding back specified deductions and exemptions.
  • Calculating alternative minimum tax as per applicable rates on the adjusted income calculated in step 1.
  • Comparing the amount calculated in step 2  to the regular income tax that is otherwise payable on normally calculated income.
  • Actual payment of the amount higher out of the two  (AMT and normal tax as per unadjusted income and applicable tax rates)

Deductions/exemptions to be adjusted under AMT

  • Deductions under section 80H to 80RRB covered under Chapter VI A of heading C.Hotel businesses, export business, housing, and infrastructure projects are a few of the industries converted under these sections.
  • Deduction under section 35 AD - Under this section, the capital expenditure when incurred for specific businesses such as cold chain facility, fertilizer production, warehousing housing is allowed as 100 % deduction all at once.
  • Deduction under section 10 AA- This deduction is allowed to units set up in special economic zones dealing with the country's exports on profits varying from 50% to 100% as per the number of years.

Alternative Minimum Tax Credit

When normal tax is lower than alternative minimum tax, Alternative Minimum Tax becomes payable. But in case, in a subsequent year, the normal tax is higher than the alternative minimum tax, the difference between normal tax and amt is allowed to be carried forward as a credit to reduce the tax liability in that particular year. If any balance remains in the credit, it is carried forward to subsequent years.

As we know, the main objective behind the Alternative Minimum Tax was not to let people with high incomes take undue advantage of deductions and exemptions available to them to bring down their tax liability much lower. Still, with time, this law has constantly been changing. Further, it has been made applicable by various means to individuals who do not even belong to these high-income brackets making it quite stressful for individuals and businesses, especially startups.

What is the connection between Alternative Minimum Tax and startup equity?

To understand the connection, we should first understand what ESOPs are. Employee stock option plans are offered to the employees of the company. Under this, they are given an option to buy a specified number of shares of the company at a later date, at a price determined now, better known as the exercise price, which is lower than the prevailing market share price of the company. This is usually opted for by startups because of no cash payments, better performance of employees, and retention of employees in the company because they can only exercise this right after a certain amount of time.

Having understood what ESOP's are, let us now understand how they are related to AMT. Suppose the employees decide to exercise this option and buy these shares at a discounted rate. In that case, the difference between the fair market value and the exercise price becomes taxable under alternative minimum tax. We can argue that this is no income, but we can't change the law.

How does it affect the employees and, in turn, the company?

Because of this provision, the company's employees may get discouraged to exercise these stock options because who would want an additional headache to deal with by just exercising stock options? 

And when that happens, all the strategies and plans as per which the ESOP was introduced, keeping in mind the goals and objectives, would see a full stop ahead. 

 Other things that happen or can happen are, equity doesn't get diluted because the number of shares does not increase. The exercise price may be manipulated and adjusted to ensure AMT liability comes out less. This could also send a negative signal in the market, thus negatively affecting the company's market value.

How does it directly affect the company? 

The effect came into the picture when corporations were removed from the view of the applicability of AMT. Before this amendment, the tax payable by the corporations used to include alternative minimum tax as well as the regular tax amount adding to the overall tax burden.

The startup's equity, as well as profitability, are very much connected. So when the additional burden was removed, the income statements got somewhat improved, further having a positive impact on the startup's equity.

Conclusion

The company, as well as its employees, should well understand the implications of AMT. Equity is a matter of great importance to the company, so everything should be well thought of before moving ahead with any plans related to it. Yes, some implications are difficult to foresee. Still, to some extent, a plan must be made and followed before moving forward to avoid negative repercussions for the employees and the company.

If you are looking for any Employee stock option plan (ESOP) services or consultants in Noida, Delhi, Gurgaon or anywhere in India, write to us at accounts@especia.co.in. Or Call On :(+91)-9711021268 +91-9310165114

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