Case study: the AMT trap when the stock crashed
A worker owed AMT on a paper gain, then the shares fell 70%. Here is what he did next and what would have saved him.
ISOs · Case studies
What happens when you owe tax on a gain that then evaporates? You can end up writing a check to the IRS that is larger than the stock is worth. That is the AMT trap, and here is a composite of someone who walked straight into it.
Names and numbers are a composite to protect the real person. The pattern shows up every time a hot stock turns cold.
The setup
Daniel exercised a big block of ISOs and held the shares, chasing the long-term capital gains rate. His incentive stock options had a low strike, the stock was flying, and the bargain element, the gap between the market price at exercise and what he paid, was large.
That bargain element is invisible to regular tax. The alternative minimum tax, the parallel tax system that adds back the ISO spread, counted every dollar of it. So Daniel owed real cash AMT for the year of the exercise, sized on the high price the stock hit the day he exercised. He did not sell a single share to pay it.
The bill was locked to the high price
AMT on an exercise-and-hold is calculated on the spread the day you exercise. It does not care what the stock does afterward. Daniel’s tax was frozen at the peak even as the shares fell. See ISOs and the AMT: the complete guide.
The crash
Then the stock dropped about 70%. Daniel was now holding shares worth a fraction of what they were at exercise, and the AMT bill from that exercise was still due. The tax on the paper gain had outlived the gain.
He had a decision most people never realize they have. The clock on a qualifying disposition, two years from grant and one year from exercise, had not run yet. Selling now would be a disqualifying disposition, an early sale that throws out the ISO treatment.
What he did
A disqualifying disposition in the same calendar year as the exercise turned out to be the escape hatch.
He sold in the same year he exercised
Selling the shares in the same tax year as the exercise unwinds the AMT preference for that exercise. The phantom income that drove the AMT goes away because there is no longer a held position carrying it.
The income flipped to ordinary on a much smaller number
A disqualifying disposition taxes the spread as ordinary income, but only the spread that actually existed at sale. With the stock down hard, that spread was small or gone, so the tax followed the real economics instead of the peak.
He stopped the bleeding instead of defending the bet
Holding to save tax would have meant paying AMT on a gain he no longer had, for the chance the stock came back. He chose the cash he could still recover over the rate he might never reach.
The AMT that drove Daniel’s bill turns on the exemption, which for 2026 is $140,200 for married filing jointly and $90,100 for single filers 2026, phasing out from $1,000,000 of AMT income for married filing jointly and $500,000 for single filers, and gone at $1,280,400 and $680,200 respectively 2026. The ordinary rate on his disqualifying disposition ran up to 37% for 2026 on taxable income over $640,600 for single filers and $768,700 for married filing jointly 2026. The long-term rate he gave up for 2026 is 0% on taxable income up to $98,900 (married filing jointly) and $49,450 (single), 15% up to $613,700 (married filing jointly) and $545,500 (single), and 20% above those 2026.
What would have saved him earlier
The disqualifying sale was damage control. The real save was available a year before the crash.
Could he have avoided the trap entirely?
Yes, two ways. He could have sold enough shares at exercise to cover the AMT, keeping only what was paid for, so a drop could not leave him underwater on the tax. Or he could have exercised early in the year and watched the stock until December, selling before year end if it fell, which keeps the disqualifying-disposition escape hatch open in the same tax year. Both trade some upside for the guarantee that a paper gain can never cost you more than the stock is worth. See why exercising early in the year cuts risk.
What this means for you
The lesson is not that exercise-and-hold is bad. The lesson is that AMT freezes your tax at the high-water mark while the stock is free to fall, so an exercise you cannot afford to see drop is an exercise sized wrong. Exercise early in the year so you can still reverse course, sell enough to cover the tax, and never bet money on a stock that the tax bill alone could bury. For the decision before you exercise, read exercise and hold vs sell. If you are sitting on a big paper gain and a tax bill, a fit check is worth the call before year end closes the exit.
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