But ISOs are also subject to the Alternative Minimum Tax (AMT), an alternative way of calculating taxes that certain filers must use. The AMT can end up taxing the ISO holder on the spread realized on exercise despite the usually favourable treatment for these awards.

But ISOs have a major disadvantage to the employee. The spread between the purchase and grant price is subject to the AMT. The AMT was enacted to prevent higher-income taxpayers from paying too little tax because they were able to take a variety of tax deductions or exclusions (such as the spread on the exercise of an ISO). It requires that taxpayers who may be subject to the tax calculate what they owe in two ways. First, they figure out how much tax they would owe using the normal tax rules. Then, they add back in to their taxable income certain deductions and exclusions they took when figuring their regular tax and, using this now higher number, calculate the AMT. These "add-backs" are called "preference items" and the spread on an incentive stock option (but not an NSO) is one of these items. For taxable income up to $175,000 or less (in 2013), the AMT tax rate is 26%; for amounts over this, the rate is 28%. If the AMT is higher, the taxpayer pays that tax instead.

One point most articles on this issue do not make clear is that if the amount paid under the AMT exceeds what would have been paid under normal tax rules that year, this AMT excess becomes a "minimum tax credit" (MTC) that can be applied in future years when normal taxes exceed the AMT amount.

**Add:**- Regular taxable income
- +Medical/dental deductions
- +Specified miscellaneous itemized deductions subject to AMT
- +State/local/real estate tax deductions
- +Personal exemptions
- +Spread on ISO exercise
- = Preliminary AMT taxable income
**Subtract:**- $AMT standard exemption ($78,750 for 2012 joint filers; $50,600 for unmarried persons; $39,375 for married filing separately. This is reduced by 25 cents for each dollar of AMT taxable income above $150,000 for couples,$112,500 for singles and $75,000 for married filing separately.)
- = Actual AMT taxable income
**Multiply:**- Actual AMT taxable income times 26% for amounts up to $175,000, plus 28% of amounts over that
- = Tentative minimum tax
**Subtract:**- Tentative minimum tax - Regular tax
- = AMT

The AMT amount, however, becomes a potential tax credit that you can subtract from a future tax bill. If in a subsequent year your regular tax exceeds your AMT, then you can apply the credit against the difference. How much you can claim depends on how much extra you paid by paying the AMT in a prior year. That provides a credit that can be used in future years. If you paid, for instance, $15,000 more because of the AMT in 2013 than you would have paid in the regular tax calculation, you can use up to $15,000 in credit in the next year. The amount you would claim would be the difference between the regular tax amount and the AMT calculation. If the regular amount is greater, you can claim that as a credit, and carry forward any unused credits for future years. So if in 2014, your regular tax is $8,000 higher than the AMT, you can claim an $8,000 credit and carry forward a credit of $7,000 until you use it up.

This explanation is, of course, the simplified version of a potentially complex matter. Anyone potentially subject to the AMT should use a tax advisor to make sure everything is done appropriately. Generally, people with incomes over $75,000 per year are AMT candidates, but there is no bright dividing line.

One way to deal with the AMT trap would be for the employee to sell some of the shares right away to generate enough cash to buy the options in the first place. So an employee would buy and sell enough shares to cover the purchase price, plus any taxes that would be due, then keeps the remaining shares as ISOs. For instance, an employee might buy 5,000 shares on which he or she has options and keep 5,000. In our example of the shares being worth $30, with an exercise price of $10, this would generate a net before taxes of 5,000 x the $20 spread, or $100,000. After taxes, this would leave about $50,000, counting payroll, state, and federal taxes all at the highest levels. In the following year, the employee has to pay AMT on the remaining $100,000 spread for shares that were not sold, which could be as much as $28,000. But the employee will have more than enough cash left over to deal with this.

Another good strategy is to exercise incentive options early in the year. That's because the employee can avoid the AMT if shares are sold prior to the end of the calendar year in which the options are exercised. For instance, assume John exercises his ISOs in January at $10 per share at a time when the shares are worth $30. There is no immediate tax, but the $20 spread is subject to the AMT, to be calculated in the next tax year. John holds on to the shares, but watches the price closely. By December, they are only worth $17. John is a higher-income taxpayer. His accountant advises him that all of the $20 spread will subject to a 26% AMT tax, meaning John will owe tax of about $5.20 per share. This is getting uncomfortably close to the $7 profit John now has on the shares. In the worst-case scenario, they fall to under $10 next year, meaning John has to pay $5.20 per share tax on shares where he has actually lost money! If, however, John sells before December 31, he can protect his gains. In exchange, he'll pay ordinary income tax on the $7 spread. The rule here is that is the sale price is less than the fair market value at exercise but more than the grant price, then ordinary income tax is due on the spread. If it is higher than the fair market value (over $30 in this example), ordinary income tax is due on the amount of the spread at exercise, and short-term capital gain tax is due on the additional difference (the amount over $30 in this example).

On the other hand, if in December the stock price still looks strong, John can hold on for another month and qualify for capital gains treatment. By exercising early in the year, he has minimized the period after December 31 he must hold the shares before making a decision to sell. The later in the year he exercises, the greater the risk that in the following tax year the price of the stock will fall precipitously. If John waits until after December 31 to sell his shares, but sells them before a one-year holding period is up, then things are really bleak. He is still subject to the AMT and has to pay ordinary income tax on the spread as well. Fortunately, almost in every case, this will push his ordinary income tax above the AMT calculation and he won't have to pay taxes twice.

Finally, if John has a lot of non-qualified options available, he could exercise a lot of those in a year in which he is also exercising his ISOs. This will raise the amount of ordinary income tax he pays and could push his total ordinary tax bill high enough so that it exceeds his AMT calculation. That would mean he would have no AMT next year to pay.

It is worth remembering that ISOs provide a tax benefit to employees who willingly take the risk of holding on to their shares. Sometimes this risk does not pan out for employees. Moreover, the real cost of the AMT is not the total amount paid on this tax but the amount by which it exceeds ordinary taxes. The real tragedy is not those who take a risk knowingly and lose, but those employees who hold onto their shares without really knowing the consequences, as the AMT is still something many employees know little or nothing about and are surprised (too late) to learn they have to pay.