Incentive stock options can be one of the most rewarding forms of equity compensation in technology, and one of the most misunderstood. Handled well, they offer a path to long-term capital gains treatment on a large amount of upside. Handled poorly, they can generate a tax bill on income you never received in cash, sometimes a very large one, at the worst possible moment.
The mechanism behind that surprise is the alternative minimum tax, or AMT. And beginning in 2026, the rules around it changed in a way that makes careful planning more important than it has been in nearly a decade. If you hold incentive stock options, understanding the AMT is not optional. It is the difference between a clean outcome and a painful one.
Here is how the trap works and how to avoid it.
How Incentive Stock Options Are Supposed to Work
The appeal of an incentive stock option, or ISO, is its tax treatment. When you exercise an ISO and hold the shares, there is no regular income tax at exercise. If you then hold the shares long enough, more than one year from exercise and more than two years from grant, the entire gain when you sell is taxed as long-term capital gain. That is a qualifying disposition, and it is the outcome the structure is designed to reward.
The catch is hidden in that middle step. Exercising and holding produces no regular taxable income, but it does produce something else.
Where the AMT Comes In
When you exercise an ISO and hold the shares, the difference between the stock’s fair market value at exercise and your strike price, known as the bargain element, is treated as income for AMT purposes. It does not show up on your regular tax return, but it does enter the parallel AMT calculation.
This is the source of the trap. You exercise, you hold, you have not sold a single share or received a dollar of cash, and yet you may owe tax on the paper gain. At a private company, where there is often no way to sell the shares, this phantom income can create a real cash bill with no liquidity behind it. People have exercised options, held through a downturn, and ended up owing AMT on value that later evaporated.
What Changed for 2026
For years, generous AMT rules meant many people could exercise sizable amounts of ISOs without triggering the tax. The 2025 tax law changed the mechanics in a way that takes effect in 2026.
- The higher AMT exemption amounts were made permanent. For 2026, the exemption is roughly ninety thousand dollars for single filers and one hundred forty thousand dollars for married couples filing jointly.
- The income level at which that exemption begins to phase out was reset sharply lower, to five hundred thousand dollars for single filers and one million dollars for joint filers.
- The phaseout rate doubled, from twenty-five percent to fifty percent.
The combination matters. The exemption now disappears at twice the previous speed and starts vanishing at much lower income. In the phaseout range, losing the exemption as income rises effectively pushes the marginal rate well above the stated AMT rates of twenty-six and twenty-eight percent, into the low forties for some households. For a high earner exercising a meaningful block of ISOs, the same exercise that produced a manageable result in 2025 can produce a materially larger bill in 2026.
The Strategies That Keep You Out of Trouble
The good news is that AMT exposure on ISOs is one of the most controllable items in a tax plan, because you generally choose when and how much to exercise. The tools below are commonly used, though the right combination depends entirely on your numbers.
- Exercise just enough each year. There is typically a threshold below which an exercise generates little or no AMT. Exercising up to that point each year, rather than all at once, can spread the bargain element across multiple years and keep you under the cliff.
- Split exercises across calendar years. Exercising part of a position in December and part in January places the income in two different tax years, which can keep each year’s AMT in check.
- Mind what else is in the year. AMT exposure depends on your total picture. Stacking a large ISO exercise on top of vesting restricted stock, a bonus, or large capital gains in the same year can push you into the steep phaseout range. Coordinating the timing of these events is often the highest-value move.
- Use a same-year sale when the stock falls. If you exercise and the share price drops, selling the shares in the same calendar year converts the transaction to a disqualifying disposition. You lose the long-term capital gains treatment, but you also remove the AMT preference, which can prevent owing tax on gains that no longer exist.
- Plan for the credit. AMT paid on an ISO exercise generally creates a minimum tax credit that can be recovered in future years when your regular tax exceeds your tentative minimum tax. The credit softens the long-run cost, but it can take years to use, so it is not a substitute for having the cash to pay the bill now.
Do Not Forget State Tax and Cash Planning
California, where many technology professionals live, has its own alternative minimum tax in addition to the federal one, so a California resident exercising ISOs should model both. More broadly, the most important discipline is cash planning. Before exercising and holding, know what the AMT bill will be and have a plan to pay it, whether from other resources or by selling enough shares. The classic mistake is exercising for the tax benefit without accounting for the tax cost.
A Long-Term Perspective
Incentive stock options are worth the effort to get right. The reward for patient, well-planned exercising is among the best tax treatment available on equity compensation. But the AMT turns a careless approach into an expensive one, and the 2026 rules have made the margin for error smaller. The faster phaseout means that high earners in particular need to model the tax before they act, not after.
The objective is to capture the favorable long-term treatment your options were designed to deliver, while never being surprised by a tax bill on money you have not received. That requires multi-year modeling, attention to everything else happening in the same tax year, and a clear plan for the cash. It is detailed work, but it is exactly the kind of detail that protects a large amount of value.
At Carrara, we help technology professionals plan ISO exercises within a complete, multi-year tax and investment strategy, coordinating with tax advisors so that equity decisions are made deliberately rather than under deadline pressure.
This article is provided for educational purposes only and does not constitute tax, legal, or investment advice. Tax rules are complex, depend on individual circumstances, and change over time. Please consult qualified tax and financial advisors before exercising options or making related decisions.