ISOs vs. NSOs: The "AMT Nightmare" No One Warns You About

You’ve put in the years at a high-growth startup. You’ve watched the valuation climb from a Series B gamble to a Series E powerhouse. Your grant of Incentive Stock Options (ISOs) is finally vested, and the strike price is a fraction of the current Fair Market Value (FMV).

On paper, you are wealthy. Common wisdom tells you that ISOs are the "gold standard" of equity because, unlike Non-Qualified Stock Options (NSOs), you don’t pay ordinary income tax when you exercise them. You feel like you’ve found a loophole: buy the stock now, hold it for a year, and pay the lower Long-Term Capital Gains rate later.

But then April rolls around. Your accountant looks at your "spread"—the difference between what you paid and what the stock is worth—and delivers the news: You owe $85,000 in Alternative Minimum Tax.

You don't have $85,000. The stock is still private, so you can't sell it to cover the bill. You are officially living the "AMT Nightmare."

To understand why this happens, we have to look at the mechanics of the two main types of employee stock options.

NSOs are straightforward and, in a way, more "honest." When you exercise an NSO, the IRS views the spread as immediate compensation. If your strike price is $1 and the FMV is $11, that $10 difference is taxed as ordinary income. Your company withholds taxes, it shows up on your W-2, and you’re done. It’s expensive upfront, but there are no surprises.

ISOs were designed to encourage long-term shareholding. Under the "Regular Tax" system, you pay $0 when you exercise. The tax is deferred until you sell the shares.

However, the IRS maintains a second, parallel tax system called the Alternative Minimum Tax (AMT).

Originally designed to prevent the ultra-wealthy from using too many deductions, the AMT adds back certain "preference items" to your income. The ISO spread is the single largest AMT preference item for tech employees.

The Math of the Trap: Imagine you exercise 10,000 ISOs with a $1 strike price while the FMV is $51.

Even though you haven't seen a single cent of actual cash from these shares, the AMT system treats that $500,000 as if it were deposited into your bank account. Depending on your other income and filing status, you could be looking at an AMT rate of 26% or 28% on that spread.

The absolute worst-case scenario—and one we see far too often—is the Illiquidity Trap.

If you exercise your ISOs in a private company and trigger a massive AMT bill, you must pay that bill with cash from your savings. If the company’s valuation drops the following year, or if the company never goes public/gets acquired, that money is gone.

You paid the IRS "real" money for "monopoly" money that you can't sell. While you do get an "AMT Credit" that can be used to lower your taxes in future years, that credit doesn't put food on the table or pay your mortgage today. Many tech employees have been forced to take out high-interest personal loans or 401(k) loans just to pay taxes on stock they aren't even allowed to sell yet.

The goal of a smart equity strategy isn't to avoid the AMT entirely—it's to dance right on the edge of it.

Every taxpayer has an AMT Exemption. This is a specific dollar amount of "extra" income you can earn before the AMT system kicks in. If you know exactly where your "Regular Tax" and "AMT Tax" meet, you can calculate the "Sweet Spot."

The Strategy: The Partial Exercise Instead of exercising all 10,000 shares and triggering a $100k tax bill, you might find that you can exercise 2,200 shares without paying a single penny in AMT.

By calculating your AMT Crossover Point, you can:

Doing this manually requires a 20-page spreadsheet and an intimate knowledge of the current year’s tax brackets, phase-outs, and exemption levels. If you guess wrong by even a small margin, the "phase-out" rules can cause your tax liability to spike exponentially.

You shouldn't need a CPA on retainer just to decide whether to click "Exercise" in your Carta dashboard. But you also shouldn't rely on "back-of-the-napkin" math when six figures are on the line.

Rally is built specifically for this moment.

Instead of guessing your AMT exposure, Rally connects directly to your financial data to provide a real-time "Tax Gap" analysis.

Most tech employees realize they have an AMT problem when they receive their tax return in April. At that point, it’s too late to undo the exercise. The time to plan is before you sign the exercise agreement.

Don't let your ISOs turn into a liability. Whether you are planning a massive exercise before a potential IPO or just want to start chipping away at your vested shares, you need to know your numbers.

Rally Tax is an Authorized IRS e-file Provider and SOC2 Compliant.

Frequently Asked Questions: 

The AMT is a parallel tax system with its own rules. When you exercise ISOs and hold the shares, the IRS calculates your "paper profit" and adds it to your taxable income for AMT purposes—even though you haven't sold the stock and have no cash from it. If your AMT calculation is higher than your regular tax, you owe the difference. This can result in a tax bill of tens or hundreds of thousands of dollars that must be paid in cash, often while your shares are still "locked" in a private company.

The Crossover Point is the exact dollar amount of ISO spread you can trigger before your AMT liability exceeds your regular income tax.

Yes, usually. When you pay AMT because of an ISO exercise, you generate an AMT Credit. This credit can be carried forward indefinitely and used to lower your tax bill in future years when your regular tax is higher than your AMT (typically the year you sell your shares). However, this is a "timing" benefit—it doesn't help you if you need that cash today for a mortgage or other expenses.

This is the "Nightmare" scenario. If you exercise ISOs at a high Fair Market Value (FMV), pay a large AMT bill, and then the stock price crashes, you cannot "undo" the tax you paid. You are left with an AMT credit that might take decades to fully use, and shares that are worth less than the tax you paid on them. This is why calculating your "Sweet Spot" and exercising incrementally is a safer strategy than a "bulk exercise."Generate My Free Structured Tax Plan

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Rally Tax is an Authorized IRS e-file Provider and SOC2 Compliant.