Incentive Stock Options and the Alternative Minimum Tax Catch-22

If you work in tech and have incentive stock options (ISOs), there’s a good chance your taxes are affected by a quirk in the tax code, created in response to an uproar in the 1960s over 155 people who had high incomes yet paid no taxes. 

That quirk is called the alternative minimum tax (AMT). Since its creation, it has been applied to far more people than initially intended. From affecting 155 people in the 1960s to 5 million in the first decades of the 2000s and approximately 200,000 taxpayers since 2018, this part of the tax code is now commonplace for people who earn part of their compensation as stock options.

Here’s why AMT can be problematic: If you exercise enough incentive stock options and continue to hold the stock from the options you exercised, you will likely generate a tax liability above your “normal” taxes. However, since you have not sold any stock, you won’t have any cash to show for it.

People with ISOs often need specialized planning to avoid getting stuck in the AMT catch-22. In this Insight, we’ll address some considerations to explore with your financial advisor.

What is alternative minimum tax?

Let us briefly review how the AMT works so that we can understand why people with ISOs (which didn’t come into being in their modern incarnation until 1981) get caught up in it. As a side note, we will focus on the Federal AMT. States can and do have their own AMT policies.  

The Tax Reform Act of 1969 set the Federal AMT in motion. By 1983, it had assumed the form we recognize today.

That form looks like this:

You calculate your taxes as usual, but then (if applicable), add back items that are not counted in the standard tax system but do count for AMT purposes. These are called “preference items.” A complete list of these can be found on Form 6251. Other than paper gains from the exercise of ISOs (called “bargain element”), common preference items include sales of Qualified Small Business Stock (QSBS) and tax-free interest on municipal bonds.

Next, you apply the special AMT exemption and AMT tax brackets, and if that calculation says you owe more than the first “normal” calculation, you pay the difference. For most people, most of the time, the AMT tax calculation is lower, so nothing is owed due to the AMT.

For taxpayers who do end up with a higher AMT than regular tax calculation, and who got there because of exercising their ISOs, there is an excellent silver lining! You get to keep track of that difference that you paid, as a credit.

Then, when you have that credit, you get to use it each year by paying the AMT or regular tax, whichever is lower.

AMT credit recovery and planning

How long will it take to utilize an AMT credit? The answer will vary from person to person and from year to year as tax law changes. As is always the case with taxes, everything affects everything else. However, this chart can give you a general idea of how much credit you could use depending on your earnings: 

Of course, if your taxable income is zero, the difference will be zero. Since the AMT has a larger exemption and so does not go into effect for a married couple with less than $100K of income, that income threshold (in 2025, $137K for couples filing jointly) is where the maximum credit utilization — a bit north of $10K per year — will be. The gap between the two, and therefore the annual credit you can utilize, shrinks as ordinary income increases. For most couples earning in the low-to-middle six figures, the amount of credit you can use yearly will probably be $5,000-$10,000.

What if my AMT credit is enormous?

If you have a huge AMT credit in the hundreds of thousands or millions of dollars, it may seem that it would take several lifetimes to recoup it. But there is good news! Because of how the calculations for cost basis work for the shares of stock you received upon exercising the ISOs, in many cases, you can supercharge the amount of credit you get back whenever you sell those shares. Often, because of that credit, the effective tax rate for selling those shares will be close to zero.

Because everyone’s tax situation is unique, there are very few blanket statements that we can make about maximizing the efficiency of an AMT credit once you have one. However, we have found that planning ahead, perhaps minimizing or eliminating the amount of credit generated upon exercise, paired with a plan to utilize the credit once it is generated, typically yields the best results. No one wants a surprise tax bill from the AMT or a large, stranded AMT credit.

The future of the alternative minimum tax credit

Writing about anything to do with taxes is an inherently tricky exercise because Congress might change the rules. This article was written with the Tax Cuts and Jobs-era rules (2018 and beyond) in mind. Many of these rules are slated to sunset at the end of 2025 if Congress does not act to extend them. If that happens, millions more people will probably be subject to the AMT. However, as of this writing, most commentators expect an extension of the current AMT provisions, meaning not much will change. 

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