The AMT Comeback: How ISO Exercises and Large Passthrough Deductions Trigger Surprises

Last Updated: October 2026

Key Takeaways

• The alternative minimum tax (AMT) is a parallel tax system under I.R.C. § 55 that disallows or defers certain deductions and adds back preference items, most notably the bargain element on the exercise of incentive stock options (ISOs).
• The 2025 One Big Beautiful Bill Act (OBBBA) permanently extended the increased AMT exemption amounts from the 2017 Tax Cuts and Jobs Act, but reduced the income thresholds at which those exemptions begin to phase out, pulling more high-income taxpayers back into the AMT system for 2026 and beyond.
• For passthrough entity owners, the interaction between the expanded state and local tax (SALT) deduction cap (now $40,000 in 2025) and the AMT’s disallowance of the SALT deduction means that a larger itemized deduction for regular tax purposes can be entirely added back for AMT purposes, creating a “phantom” benefit.
• The AMT paid on ISO deferral items generates a minimum tax credit under I.R.C. § 53, but the credit is recoverable only when the taxpayer later sells the ISO stock or has regular tax liability exceeding tentative minimum tax in a subsequent year.
• THIS ARTICLE IS FOR INFORMATIONAL PURPOSES ONLY AND DOES NOT CONSTITUTE LEGAL ADVICE. THE INFORMATION MAY BE OUTDATED AND YOU ARE NOT TO RELY ON IT. CONTACT YOUR PROFESSIONAL TO GUIDE YOU BASED ON YOUR CURRENT SITUATION, OR WHAT MAY APPLY TO PREVIOUS YEARS. THIS ARTICLE IS ONLY MEANT TO PROVIDE GENERAL INFORMATION AND NOT A SPECIFIC ANSWER. YOU ARE NOT OUR CLIENT AND WE HAVE NOT ADVISED YOU.

Introduction

The alternative minimum tax (AMT) was designed as a backstop to ensure that high-income taxpayers with substantial deductions and preferences pay at least a minimum amount of federal income tax. For years after the 2017 Tax Cuts and Jobs Act (TCJA) dramatically increased the AMT exemption, the tax seemed to fade into the background for most individuals. That respite is ending.

The 2025 One Big Beautiful Bill Act (OBBBA) made the increased exemption amounts permanent but lowered the phaseout thresholds and doubled the phaseout rate from 25% to 50% of income above the threshold. The result is a narrower window of full exemption and a steeper cliff for high earners. At the same time, two distinct taxpayer profiles are finding themselves caught in the AMT web: employees exercising incentive stock options (ISOs) and owners of passthrough entities who benefit from the expanded SALT deduction cap but then lose that benefit for AMT purposes.

This article examines the statutory basis of the AMT, its place in the federal tax hierarchy of authority, the binding effect of the relevant authorities, the key cases that define how the AMT applies to ISOs, and the practical planning steps tax professionals should consider.

What Is the Alternative Minimum Tax? Definition and Statutory Basis

The AMT is a separate, parallel income tax imposed by I.R.C. § 55 on non-corporate taxpayers when their tentative minimum tax exceeds their regular tax liability for the year. It operates by requiring taxpayers to compute alternative minimum taxable income (AMTI) by adding back certain “adjustments” and “preference items” to regular taxable income, then applying a graduated rate structure (26% and 28%) to the excess of AMTI over an exemption amount.

Definitions

• Alternative Minimum Taxable Income (AMTI): The tax base for the AMT, defined as regular taxable income with adjustments under I.R.C. § 56 and increased by items of tax preference under I.R.C. § 57. See Treas. Reg. § 1.55-1(a).
• Incentive Stock Option (ISO): A statutory stock option that meets the requirements of I.R.C. § 422(b), including a $100,000 annual vesting limitation and a two-year holding period from grant and one-year holding period from exercise.
• Bargain Element: The excess of the fair market value of the stock on the date of exercise over the option exercise price. For AMT purposes, this amount is treated as ordinary income in the year the ISO is exercised, even though no regular tax income is recognized.
• Minimum Tax Credit: A credit under I.R.C. § 53 allowed for AMT paid in prior years that was attributable to “deferral items” (as opposed to “exclusion items”), such as the ISO bargain element. The credit carries forward indefinitely but is not refundable in full upon sale of the stock.
• Passthrough Entity Tax (PTET): An entity-level state income tax imposed on partnerships and S corporations (or LLCs taxed as such) that is deductible for federal income tax purposes, effectively bypassing the individual SALT deduction cap. See IRS Notice 2020-75, 2020-49 I.R.B. 1113.

The statutory architecture of the AMT consists of three interrelated sections. I.R.C. § 55 imposes the tax and defines the exemption and rates. I.R.C. § 56 specifies the adjustments to regular taxable income, including the critical ISO adjustment in § 56(b)(3), which provides that I.R.C. § 421 (the non-recognition rule for statutory stock options) does not apply for AMT purposes. I.R.C. § 57 lists the items of tax preference, including the excess of the deduction for state and local taxes paid over the amount allowable for regular tax purposes.

Binding Effect and Legal Weight

The AMT statutes are primary authority with the highest binding effect on all taxpayers, the IRS, and the courts. Treasury Regulations issued under the AMT statutes are primary authority that bind the IRS and are entitled to deference by the courts under the framework of Chevron, U.S.A., Inc. v. Nat. Res. Def. Council, Inc., 467 U.S. 837 (1984) (as modified by Loper Bright Enterprises v. Raimondo, 603 U.S. 369 (2024), which ended Chevron deference but left the persuasive weight of regulations intact). Case law from the U.S. Tax Court and the Courts of Appeals is primary authority with precedential effect within the relevant jurisdiction.

Authority Type	Primary or Secondary?	Binds IRS?	Binds Courts?	Binds Taxpayers?	Precedential Value?
U.S. Constitution	Primary	Yes	Yes	Yes	Supreme law; controls all
Internal Revenue Code	Primary	Yes	Yes	Yes	Nationwide statutory mandate
Treasury Regulations	Primary	Yes	Deference (post-Loper Bright, persuasive)	Yes	Legislative regulations: strong deference; interpretive: persuasive
U.S. Supreme Court Decisions	Primary	Yes	Yes	Yes	Nationwide binding precedent
Circuit Court of Appeals Decisions	Primary	Yes (within circuit)	Yes (within circuit)	Yes	Binding within circuit; persuasive elsewhere
U.S. Tax Court Decisions	Primary	Yes (for the case)	No	Yes (for the case)	Persuasive; appealed to circuit
Revenue Rulings	Primary (IRS guidance)	Yes	No	Generally no; IRS follows its own rulings	IRS position; can be revoked
Private Letter Rulings	Secondary	Only to the requesting taxpayer	No	No (may be cited as precedent)	No precedential value; § 6110(k)(3)
Form Instructions	Secondary	No	No	No	Administrative guidance only

Key point: The IRS is bound by its own published guidance, including Revenue Rulings, until they are revoked or modified. However, private letter rulings may not be used or cited as precedent by any taxpayer other than the one who requested it. I.R.C. § 6110(k)(3).

Key Authorities and Cases

Statutory Authority

The core statutory authority for the AMT and its interaction with ISOs is found in Subchapter A, Part VI of the Internal Revenue Code:

• I.R.C. § 55 – Imposition of the alternative minimum tax; exemption amounts; rates.
• I.R.C. § 56 – Adjustments in computing AMTI; § 56(b)(3) specifically provides that § 421 does not apply to ISOs for AMT purposes.
• I.R.C. § 57 – Items of tax preference, including the SALT deduction add-back.
• I.R.C. § 53 – Minimum tax credit for prior year AMT liability attributable to deferral items.
• I.R.C. § 422(b) – Definition of an incentive stock option.

Treasury Regulations

• Treas. Reg. § 1.55-1 – General rule for computing alternative minimum taxable income. Provides that, except as otherwise provided, all Code provisions that apply in determining regular taxable income also apply in determining AMTI.
• Treas. Reg. § 1.56-1 – Adjustments in computing AMTI.
• Treas. Reg. § 1.57-1 – Items of tax preference.
• Treas. Reg. § 1.53-1 – Minimum tax credit.

IRS Guidance

• IRS Form 6251, Alternative Minimum Tax—Individuals – The form on which the AMT is computed. Line 2i captures the ISO adjustment (excess of AMT income over regular tax income from ISO exercise).
• IRS Form 8801, Credit for Prior Year Minimum Tax – Used to compute the minimum tax credit and carryforward.
• Instructions for Form 6251 (2025) – Provides detailed rules for the ISO adjustment and the AMT exemption phaseout.
• IRS Notice 2020-75, 2020-49 I.R.B. 1113 – Confirms that state and local income taxes imposed on and paid by a partnership or S corporation are deductible by the entity in computing its non-separately stated taxable income or loss for the taxable year of payment, and are not subject to the SALT deduction cap at the partner or shareholder level.

Key Case Law

The following cases are the leading authorities on the AMT treatment of ISOs. All are primary authority and are binding within their respective jurisdictions.

• Merlo v. Commissioner, 126 T.C. 205 (2006), aff’d, 492 F.3d 618 (5th Cir. 2007) – The Tax Court held that for AMT purposes, stock acquired through the exercise of an ISO is treated as stock acquired through a nonqualified stock option under I.R.C. § 83. The court further held that capital loss limitations under I.R.C. §§ 1211 and 1212 apply in computing AMTI, preventing the taxpayer from carrying back a large AMT capital loss to offset the AMT income recognized on exercise. View on CourtListener.
• Palahnuk v. Commissioner, 127 T.C. 118 (2006) – The Tax Court clarified that the difference between regular tax and AMT capital gains or losses from ISOs must be considered in computing AMTI, but such difference does not constitute an alternative tax net operating loss (ATNOL). The case is frequently cited for its holding on the computation of AMT basis in ISO stock. View on CourtListener.
• Kadillak v. Commissioner, 127 T.C. 184 (2006), aff’d, 2008 WL 2840881 (9th Cir. July 25, 2008) – The Tax Court held that a § 83(b) election to recognize AMT income on nonvested shares acquired through an ISO exercise was valid, and that the taxpayer was not entitled to an AMT ordinary loss under I.R.C. § 1341 for stock forfeited under a lapse provision. View on CourtListener.
• Chou v. Commissioner, T.C. Memo. 2007-102 – This memorandum decision addressed a common factual pattern involving the AMT on ISOs exercised in 2000 followed by a market decline. The court considered innocent spouse relief and the computation of AMT capital loss carryforwards in the context of a joint return where one spouse was unaware of the ISO exercise. View on CourtListener.

Practical Application in Tax Practice

The AMT rarely arises in isolation. Tax professionals should incorporate AMT modeling into every engagement involving ISO exercises, passthrough entity K-1s with large state tax deductions, and high-income clients with significant itemized deductions. The following checklist outlines the core steps:

For ISO Holders:

• Model the AMT before exercise. Use a “mock” Form 6251 to estimate the tentative minimum tax based on the projected bargain element, the taxpayer’s other AMT adjustments and preferences, and the applicable exemption amount.
• Consider the “AMT crossover point.” Calculate the amount of ISO spread that can be recognized in a given year before AMT liability is triggered. For a single filer with $100,000 of regular income in 2025, the crossover point may be approximately $40,800 of ISO spread.
• Coordinate exercise timing with stock sales. The AMT credit generated by a deferral item is recovered when the taxpayer has regular tax liability in excess of tentative minimum tax in a later year. Selling ISO stock in a later year when regular tax rates are higher (e.g., after a bonus year) can accelerate credit recovery.
• Be aware of the “double tax” risk. If the stock declines in value after exercise, the taxpayer may have paid AMT on a bargain element that no longer exists. While the subsequent sale generates a negative AMT adjustment (an AMT capital loss), the capital loss limitations of §§ 1211 and 1212 apply for AMT purposes, as Merlo confirms.

For Passthrough Entity Owners:

• Evaluate the PTET election. More than 30 states have enacted a passthrough entity tax as a workaround to the SALT deduction cap. The entity-level tax is deductible for federal income tax purposes, and the owner receives a corresponding state tax credit. This structure is particularly valuable for owners in high-tax states who itemize deductions.
• Understand the AMT interaction. The expanded SALT deduction cap ($40,000 in 2025) allows a larger regular tax deduction for state and local taxes. However, for AMT purposes, the SALT deduction is disallowed under § 56(b)(1)(A)(ii). A taxpayer who deducts $40,000 of SALT for regular tax purposes must add that amount back to AMTI, potentially triggering AMT liability. The OBBBA’s reduction of the AMT phaseout threshold to $500,000 (single) and $1,000,000 (joint) for 2026 means that more taxpayers claiming the expanded SALT deduction will face this add-back.
• Model the combined effect. Run parallel regular tax and AMT projections for any passthrough owner whose state tax deduction exceeds $10,000 and whose AMTI approaches the exemption phaseout range.

Interaction with Other Authorities

The AMT occupies a unique position in the hierarchy of tax authority because it is a parallel tax system that interacts with—and sometimes overrides—the regular tax rules. The following interactions are the most significant for practitioners:

• Statute vs. Regulation: Where the Internal Revenue Code is clear, the statute controls. The regulations under § 1.55-1(a) provide that “all Internal Revenue Code provisions that apply in determining the regular taxable income of a taxpayer also apply in determining the alternative minimum taxable income of the taxpayer” unless otherwise provided. Where a regulation conflicts with the plain text of a statute, the statute prevails under the principle of legislative supremacy.
• Statute vs. Case Law: The courts interpret the AMT statutes and their application to specific fact patterns. Merlo, Palahnuk, and Kadillak are binding within their respective circuits and are persuasive authority elsewhere. A taxpayer in the Fifth Circuit, for example, is bound by Merlo on the treatment of ISO stock as NSO stock for AMT purposes.
• AMT vs. Regular Tax: The AMT is imposed only if tentative minimum tax exceeds regular tax. A taxpayer who pays AMT in one year may recover that tax through the minimum tax credit in a later year. This creates a temporal dimension to the hierarchy: the regular tax rules control in the year of exercise, while the AMT rules control the computation of AMTI, and the credit rules under § 53 control recovery in subsequent years.
• Federal vs. State: The AMT is a federal tax. State AMT rules, where they exist, are separate and distinct. A state passthrough entity tax election does not affect the federal AMT computation except insofar as it changes the regular tax deduction for state taxes (which is then added back for AMT purposes).

Frequently Asked Questions

What is the AMT and who has to pay it?

The AMT is a parallel tax system that applies when a taxpayer’s tentative minimum tax exceeds their regular tax liability. Taxpayers with significant ISO exercises, large SALT deductions, or other preference items are most likely to owe AMT. The tax is computed on Form 6251 and attaches to the return only if the tentative minimum tax exceeds regular tax.

Does exercising an ISO always trigger the AMT?

No. Exercising an ISO triggers an AMT adjustment equal to the bargain element, but AMT liability arises only if the taxpayer’s total AMTI (including the bargain element and other adjustments) exceeds the exemption amount and the tentative minimum tax exceeds regular tax. A taxpayer with a relatively small ISO spread and no other preference items may exercise without incurring AMT liability.

Can I get a refund of AMT paid on an ISO exercise?

Yes, but the recovery is structured as a credit, not a direct refund. The AMT paid on the ISO bargain element is a “deferral item” that generates a minimum tax credit under § 53. The credit is claimed on Form 8801 and carries forward indefinitely until it can be used against regular tax liability in a year when regular tax exceeds tentative minimum tax.

How does the expanded SALT deduction cap affect the AMT?

The OBBBA raised the SALT deduction cap to $40,000 for 2025 (with a phaseout for MAGI above $500,000), but the SALT deduction is still disallowed for AMT purposes under § 56(b)(1)(A)(ii). A taxpayer who claims the full $40,000 SALT deduction for regular tax purposes must add that amount back to AMTI, which can push them into AMT territory. The OBBBA’s reduction of the AMT exemption phaseout thresholds for 2026 makes this interaction even more significant for high-income taxpayers.

What planning strategies can reduce or eliminate AMT on ISOs?

The most effective strategies include exercising ISOs early in the calendar year (to allow more time to assess the stock’s value and potentially sell before year-end), staggering exercises across multiple tax years to stay below the AMT crossover point, and coordinating ISO exercises with years in which the taxpayer has high regular tax liability (to accelerate recovery of the minimum tax credit). A “disqualifying disposition” (selling the stock in the same year as exercise) eliminates the AMT adjustment but converts the gain to ordinary income.

Conclusion

The AMT comeback is not a return to the pre-2017 status quo. It is a more targeted, more complex regime in which the OBBBA’s permanent exemption increases are offset by steeper phaseouts and a doubling of the phaseout rate. For ISO holders and passthrough entity owners, the practical effect is that the AMT is no longer a remote risk confined to the very wealthy. It is a planning consideration that must be modeled before any ISO exercise and before any decision to rely on the expanded SALT deduction.

The hierarchy of authority matters here. The statute under § 55, § 56, and § 57 is the supreme law. The regulations under § 1.55-1 provide the computational framework. The cases—Merlo, Palahnuk, Kadillak, and Chou—define the boundaries of the ISO adjustment and the credit recovery. And the IRS forms and instructions provide the mechanical rules that taxpayers and practitioners must follow. When these authorities conflict, the statute prevails; when they are silent, the regulations and case law fill the gaps.

Limitations: This article addresses the federal AMT rules as of October 2026. State AMT rules vary and are not discussed. The OBBBA provisions are subject to future legislative change. The interaction between the AMT and the alternative tax net operating loss (ATNOL) rules is complex and fact-specific. Practitioners should consult the primary sources cited herein and model each client’s situation individually. This article is not legal advice.

Author Bio

Alan Goldstein is an Enrolled Agent and researcher with 26 years of experience in federal and state tax controversy. He advises high-net-worth families and closely held businesses on income-shifting strategies, charitable planning, and IRS audit defense.

Last Updated: October 2026

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