Incentive Stock Options and Alternative Minimum Tax
If you’ve worked in technology startup companies for even a short time, you’ve probably heard stories or known colleagues who exercised stock options and got into trouble with alternative minimum tax (AMT). Often, these stories involved incentive stock options (ISOs) and a drop in the company’s stock price after employees exercised their options.
While ISOs have potentially tax-saving features that non-qualified stock options don’t, ISO taxation is more complicated and has potential pitfalls worth careful consideration.
ISOs and Regular Tax Rules
Under regular tax rules, when you exercise an ISO, any gain in value that results from an increase in the stock price above the strike price becomes taxable when you sell the shares.
ISOs receive special tax treatment under the regular tax system if you meet holding-period requirements. If you hold your shares for two years from the date you received your stock option and one year after you exercised your option, the gain on sale is taxed at favorable long-term capital gain tax rates instead of higher ordinary income tax rates.
If you sell your exercised shares before the holding period, then you will not receive special tax treatment, and your sale will be taxed in one of three ways. If the sale price is less than the amount you paid for the shares (exercise price), you will have a capital loss. If the sale price is above the exercise price but less than the market price when you exercised, your gain will be taxed as ordinary income. If the sale price is above the market price when you exercised, your sale will be taxed in two parts: (1) The portion of gain per share equal to market price at exercise minus the exercise price will be taxed as ordinary income, and (2) the portion of gain per share equal to market price at sale less market price at exercise will be taxed as either short-term or long-term capital gain depending on how long you held the shares.
ISOs and AMT
The treatment of ISOs under the AMT system differs from treatment under the regular tax system and must be considered separately. First, a quick refresher on AMT.
The AMT system is a second tax system in addition to the regular tax system. On your federal tax return, you must calculate your tax owed under both systems and pay the higher amount. If your tax is higher under the AMT system, you report the extra AMT tax owed (above your regular tax) on your tax return as AMT. Most people refer to this as “paying AMT,” although it represents the difference between the two calculations.
Under the AMT system, any gain in the value of your ISO shares is taxed when you exercise your option instead of when you later sell your shares, as under the regular tax system. The AMT doesn’t impose tax when you first receive the option.
AMT tax treatment of your ISO shares further depends on when you sell them. If you sell your ISO shares within the year you exercised your option, the AMT tax treatment is the same as under the regular tax system, as described above.
If you sell your ISO shares after the year you exercised your option, any gain is income under the AMT system. This situation commonly occurs when you hold shares to qualify for favorable long-term capital gains treatment under the regular tax system. Depending on your individual circumstances, this AMT tax treatment of your ISO shares can wipe out much of the regular tax savings from meeting the holding-period requirement.
The potential snag mentioned at the beginning of this article happens in this circumstance: If you exercise an ISO with the intent of holding your shares to get long-term capital gain treatment under the regular tax system, the gain becomes taxable under the AMT system on exercise. You will owe tax under the AMT system. If the stock price drops before you sell your shares, your AMT liability remains unchanged. The value of your stock holdings might even fall below the tax you owe under the AMT system as a result of exercising, so that even if you sell the stock, you may not have enough money to pay the tax owed, and you will have to use other assets to pay the tax.
One important offsetting benefit: AMT paid as a result of exercising ISOs generates a minimum tax credit that may be used to reduce your regular tax in future years. When you eventually sell the ISO shares, the AMT credit can offset some or all of the regular tax owed on the sale, effectively recovering the AMT you previously paid. Your tax advisor can help you track and apply this credit using IRS Form 8801.
Recommendations
In 2026, changes enacted under the One Big Beautiful Bill Act lowered the AMT exemption phaseout thresholds and doubled the phaseout rate from 25% to 50%. As a result, ISO exercises are more likely to trigger AMT, and potentially at higher amounts, making the tax projection exercise described here even more important.
One way to manage AMT risk that some taxpayers consider is to sell enough shares to cover the expected tax liability. In certain situations, setting aside those proceeds may help funds remain available even if the stock price declines after exercise.
We also recommend running tax projections to determine whether exercising and meeting the holding-period requirement is beneficial in your situation. While the exercise-and-hold tax strategy for ISOs can lower your tax under the regular tax system, AMT tax treatment of ISOs offsets much of the reduction in many cases. Preparing tax projections under both the regular and AMT systems under various holding-period assumptions can help you determine whether the tax benefits of holding are worth the risk of a stock price drop.
Savant Wealth Management provides holistic wealth management services, including financial planning, equity compensation planning, investment management, tax planning, and others, on a fee-only basis and as a fiduciary, acting in clients’ best interests. If you’d like to explore how we can help you build and protect your wealth, schedule a complimentary consultation.
This is intended for informational purposes only. You should not assume that any discussion or information contained in this document serves as the receipt of, or as a substitute for, personalized investment or tax advice from Savant. Please consult your investment or tax professional regarding your unique situation.
Bruce R. Barton
Managing Partner / Financial Advisor
CFP®, CFA®, MBA