Year-end Planning for Incentive Stock Options

Incentive Stock Options At Year-End

ISOs are quite often exercised with the intention of holding the stock to qualify for long-term capital gains treatment on the full gain over the exercise price. You may be holding ISO stock because of the opportunity presented by a dramatic drop in stock prices this year or any one of the last several volatile years. Alert employees may have jumped at the chance to exercise ISO grants that were made when the company's stock price was abnormally low (see my article on managing market volatility).

Other recipients of ISOs are employees of companies that went through an IPO this year or last (see my article on financial planning at IPO companies). It may be time to decide whether the moment is right to take long-term gains on ISO shares you still have or use the current uneven market to your advantage.

If you exercised ISOs in 2025 and before, any dramatic drop in your company's stock price should make you carefully examine your strategy. Some of those shares are trading at prices below where they were exercised; others have fallen from their highs but still trade above their exercise price. Both situations could, nevertheless, leave you with an alternative minimum tax (AMT) conundrum.

A down or volatile stock price may entice you to either (1) exercise ISOs you previously avoided because of the potentially large AMT you'd owe on the spread or (2) sell ISO stock before year-end to eliminate the AMT on shares you acquired from exercises when the market price was higher.

Determine Your Alternative Minimum Tax (AMT) Opportunity

Under the Tax Cut and Jobs Act (TCJA), the Alternative Minimum Tax (AMT) calculation dramatically changed. While the AMT didn't go away, the rules were a bit more friendly to taxpayers than they were before 2018. In July 2025, the "One Big Beautiful Bill" Act (OBBBA) became law. The OBBBA changes the AMT income exemption amounts of the Tax Cuts & Jobs Act (TCJA) beginning in 2026.

Final year of TCJA on AMT

Under the rules that will continue through 2025, taxpayers with high levels of AMT income, have an AMT exemption that is phased out which increases the odds that they will owe the AMT. The TCJA dramatically increased the phase-out thresholds to levels where most taxpayers are unaffected by the phase-out rule. For 2025, the exemption begins to be phased out when AMT income exceeds $626,350 for a single filer or $1,252,700 for a married joint-filing couple and the exemption is reduced by 25% of the excess of AMT income over the applicable phase-out threshold.

2025 AMT income exemption amounts, phaseouts, and rate thresholds

OBBBA Changes to AMT Begin in 2026

The enlarged AMT exemption and higher exemption phaseouts benefit people who had to pay the AMT in prior years. These taxpayers generated an AMT credit when they exercised ISOs and held the associated stock with the expectation that they would get long-term capital gains tax treatment on the full appreciation at the eventual sale of the shares.

Named the Minimum Tax Credit (MTC) back in 1986 when it was adopted, the credit provided for a carryforward that was expected to be used in future years. But it turned out that some of these taxpayers couldn't ever use their MTC. Due to the previously low exemptions and equally low phaseouts, they continued to be subject to the AMT, year after year, because of high income, big deductions, and/or additional ISO exercises.

Under TCJA, lots of taxpayers were able to use up most of their MTC because of the higher AMT exemption and phaseout point. A much larger gap between the household's regular tax and AMT let them claim their credit carryforwards.

But, in 2026 the OBBBA will reset the exemption phase-out thresholds to the pre-TCJA levels of $500,000 and $1,000,000 and increase the exemption phase-out percentage from 25% to 50%. So, for 2026 and beyond, AMT exemptions for high-income taxpayers will be phased out more quickly. This means more people may owe the AMT, and more people who were already in the AMT will probably pay higher AMT tax bills.

High income earners are more likely to be at risk for unexpected AMT when the reason their income is high is because they exercised incentive stock options but that’s not the only AMT trap. Other sources of income that can give rise to AMT include:

1. Capital gains. Big gains could cause the AMT exemption to be phased out.
2. Itemized deductions, especially the State and Local Tax (SALT) deduction. The OBBBA raises the SALT deduction to $40,000 but the deduction is subject to a 30% phase out for Modified AGI above $500,000.
3. Standard deductions are disallowed under the AMT. Higher standard deductions counterintuitively raise the risk of AMT.
4. Private activity municipal bond interest is attractive to high income taxpayers, but the interest is a “preference item” and must be added back when AMT is calculated.

The final year of TCJA AMT is an opportunity.

Calculate your AMT Cushion

Stock-price drops mean more shares can potentially be exercised without triggering the AMT. If you have not already exercised any ISOs this year, ask your accountant to determine your AMT spread and cushion. This spread is the difference between your ordinary tax and your AMT obligation. Even though itemized deductions have been reduced under the new tax law, the spread at ISO exercise can be large enough to trigger the AMT. If you calculate that your 2025 ordinary tax is greater than your AMT, you have an opportunity to exercise some more ISOs without owing any additional tax.

Example: Your accountant says that your ordinary tax is $70,000 and your AMT is $60,000, meaning you have a $10,000 AMT spread. You can generate an additional $10,000 of AMT without paying any extra taxes. Assuming you are in the 28% AMT bracket, you may be able to exercise ISOs with a spread of $35,714 without paying any additional tax (this generates $9,999 of AMT). The exercise begins your holding period to qualify for long-term capital gains. As a result, you will be able to sell the stock after one year from exercise (two years from grant) and pay only the lower long-term capital gains tax on the full increase over your exercise price.

This may not be to your advantage if you currently have an AMT credit carryforward from last year. (Of course, you should confirm any tax calculations with your accountant and other advisors.) However, the AMT spread sometimes provides an opportunity to generate income without generating additional tax.

Decide About ISO Stock That Has Lost Value Since Exercise

The beginning of the year is often the time when equity-holders decide to exercise ISOs to get the long-term capital gains clock ticking. If you exercised and held ISOs this year and the stock has dropped in value since exercise, you have to make an important decision. Should you sell the stock before the end of the year of exercise to eliminate the AMT, or should you simply sit still and hope the stock price will recover?

Example: You have an exercise price of $10. You exercised your option on January 15 of this year, when the stock had a value of $50. You generated $40 per share of alternative minimum taxable income (AMTI). If you are in the 28% AMT bracket, you will owe $11.20 per share of AMT (with an AMT credit to use in future years). You plan to hold the stock until January 16 of the next year. You intend to sell the stock and pay only long-term capital gains on the profit.

However, on December 1 the stock is trading at only $20 per share. If you sell the stock, your tax calculation changes substantially: selling the stock is a disqualifying disposition, and the gain is taxed as ordinary income. The gain, though, is limited to the difference between your exercise price ($10) and sale price ($20). You will have only $10 per share of ordinary income. If you are in the 37% top federal tax bracket you will owe $3.70 per share. The original AMT is simply eliminated.

You must make a decision. If you sell in December, you will have to pay only $3.70 of tax. If you wait until January of the following year, you will have to pay the AMT of $11.20. You will get a credit for some of the AMT, but it may not be easily usable. Therefore, you may want to sell in December to eliminate the AMT liability.

Of course, the numbers all change for the better if you do not sell in December and the stock recovers to $50 per share in the following year. Although you will still owe the $11.20 of AMT, you will make a lot more money by selling at $50 instead of at $20 per share. In this situation, you should consider selling if you are concerned that the stock price may not appreciate, or if you do not have the funds to pay the AMT. If you have the money to pay the AMT and expect the stock to appreciate, waiting to sell may still be worth considering

Evaluate Your Own ISO Situation

It's important to determine:

• your AMT liability without a sale
• your ordinary tax liability if you sell
• how you will pay your AMT if you don't sell

In addition, remember to factor in your confidence in the future value of your stock. If you think the stock is going to appreciate substantially, waiting is your best choice. Exercising ISOs early in the year to start the 12-month holding period gives you more time to watch the stock so that you can decide whether a disqualifying disposition is prudent.

Consider Year-End Gifts Of Appreciated ISO Stock

The long-term capital gains tax rate on people in the 12% tax bracket is 0%. You may have adult children, retired parents, or other lower-income family members who file their own tax returns and whose income is likely to be in the 12% tax bracket. If so, they will pay the 0% tax rate on any long-term capital gains that don't raise their income to the next bracket. Consider giving these family members a gift of appreciated shares before year-end up to the annual gift limit ($19,000 per person, per gift). Gifting highly appreciated ISO shares can also be a wise way to remove value from your taxable estate, though you should be aware of the kiddie tax rules and the caution about gifting ISO stock discussed below.

Beware Of Gifting ISO Stock Too Early

Don't get carried away by the holiday spirit! Gifting stock that is generated from the exercise of an ISO is considered a disposition. If you have not met the required holding periods and you gift the stock, the gain at exercise is taxed as ordinary income in what is called a disqualifying disposition. This includes gifts to charities, family members, or others. Therefore, you may not want to gift the stock until you have met the ISO holding periods. Other planning issues arise if you triggered the alternative minimum tax when you exercised ISOs to acquire the shares that you later gifted.