Exercising Incentive Stock Options (ISOs) can meaningfully change your U.S. tax picture because of the Alternative Minimum Tax (AMT). The key driver is the bargain element—the difference between the Fair Market Value (FMV) of your company stock at the time you exercise and your strike (exercise) price. That spread is an AMT preference item that increases Alternative Minimum Taxable Income (AMTI), potentially triggering AMT in the year of exercise. In this complete guide, you'll learn how ISO taxation works at grant, exercise, and sale; how to calculate the bargain element; how qualifying vs disqualifying dispositions differ; how to model AMT using IRS Form 6251 concepts; and practical planning strategies to avoid unpleasant surprises.
What Are ISOs and How Are They Taxed?
Incentive Stock Options (ISOs) are a type of employee stock option that can qualify for favorable long-term capital gains treatment if holding period rules are met. ISOs differ from NSOs (nonqualified stock options) and RSUs (restricted stock units) in timing and character of income:
- At grant: No tax for ISOs.
- At exercise: No regular income tax; however, AMT preference is recognized equal to the bargain element.
- At sale: If holding periods are met (qualifying disposition), the entire spread between sale price and strike may be long-term capital gains. Otherwise (disqualifying disposition), some or all spread is ordinary income.
Because the AMT system runs in parallel with the regular tax system, you can owe AMT even when regular tax appears modest in the exercise year.
ISO Bargain Element: The AMT Trigger
The bargain element is:
Example: If your strike price is $5, FMV at exercise is $25, and you exercise 1,000 shares, the bargain element is (25 − 5) × 1,000 = $20,000. That $20,000 increases AMTI and is reported on IRS Form 6251 (Alternative Minimum Tax—Individuals).
AMT Basics: Exemption, Thresholds, and TMT
The AMT system calculates a parallel tax using AMTI and specific rates. You may be able to subtract an AMT exemption (subject to phase-out at higher incomes). Then AMTI after exemption is taxed at 26% up to a threshold and 28% above it. The result is called the Tentative Minimum Tax (TMT). If TMT exceeds your regular tax, the difference is AMT owed.
- AMTI: Your regular taxable income adjusted for AMT preferences (including the ISO bargain element).
- AMT exemption: Reduces AMTI; phase-out may apply for high incomes.
- Rates: 26%/28% applied to AMTI after exemption to compute TMT.
- AMT owed: max(0, TMT − Regular Tax).
Although this article uses simplified thresholds and exemption figures for illustration, you should check current-year values and consider working with a CPA for precise modeling.
Holding Period Rules: Qualifying vs Disqualifying Dispositions
ISOs achieve their best tax treatment if you meet both holding periods:
- Hold the stock for at least 1 year after exercise, and
- Sell the stock at least 2 years after the grant date.
A sale that meets these rules is a qualifying disposition. The spread between sale price and strike is generally long-term capital gain. A sale that violates either rule is a disqualifying disposition, and some or all of the spread becomes ordinary income in the sale year. Note that regardless of the later sale, the bargain element at exercise still affects AMT in the exercise year.
Step-by-Step Example: End-to-End ISO AMT Calculation
- Facts: 1,000 shares; strike $5; FMV at exercise $25; regular taxable income $120,000; regular tax $18,000.
- Bargain element: (25 − 5) × 1,000 = $20,000.
- AMTI: $120,000 + $20,000 = $140,000.
- AMT exemption: Apply current-year exemption (simplified here for illustration).
- TMT: Tax AMTI after exemption at 26%/28%.
- AMT owed: max(0, TMT − $18,000).
Depending on your exemption and exact thresholds, your TMT may be below regular tax (no AMT due) or above (AMT owed). Use a calculator to compare scenarios.
Qualifying vs Disqualifying Sale Scenarios
Scenario A: Qualifying Disposition (Favorable Long-Term Rates)
- You exercise and hold for at least 1 year, and also at least 2 years from grant before selling.
- At sale, gains are generally long-term capital gains (strike to sale price).
- However, the exercise-year AMT due to the bargain element still applies.
Scenario B: Disqualifying Disposition (Ordinary Income at Sale)
- You exercise and sell within a year or before 2 years from grant.
- Some or all of the spread becomes ordinary income in the sale year; any remainder may be capital gains.
- A later disqualifying sale can help unlock AMT credit in future years.
Practical ISO AMT Planning Strategies
- Model before you exercise: Use the ISO AMT Calculator to estimate AMT at different exercise sizes and FMVs.
- Stagger exercises: Spread exercises across calendar years to manage AMTI and preserve exemption.
- Monitor FMV: Large jumps in company valuation can dramatically increase the bargain element.
- Coordinate with income: High regular taxable income plus a large bargain element may push you into AMT.
- Track holding periods: Plan sale dates to qualify for long-term capital gains when possible.
- Document everything: Keep grant letters, exercise confirmations, and 409A/FMVs for your tax files.
Common Questions About ISOs and AMT
Does ISO exercise always cause AMT?
No. It depends on your total AMTI, exemption, and regular tax. Small bargain elements may not push you into AMT.
Can I avoid AMT by selling immediately?
A same-day sale (cashless exercise) with ISOs is often treated as a disqualifying disposition; the spread is ordinary income. While this can reduce AMT, it also forfeits ISO long-term capital gains benefits. Compare with NSOs and RSUs for cash flow planning.
What about AMT exemption phase-outs?
At higher AMTI levels, the exemption phases out, increasing TMT. Advanced modeling (and a CPA) is recommended for large exercises.
Key Takeaways
- ISOs are attractive but can trigger AMT in the exercise year via the bargain element.
- Meeting holding periods can result in long-term capital gains on sale, but doesn’t eliminate exercise-year AMT.
- Plan ISO exercises with a calculator, consider staged approaches, and track holding periods and valuations.
Next, learn how the AMT credit works and when you can use it to offset regular tax in future years, or compare equity types in Equity Compensation 101.
