Incentive Stock Options (ISO)
Definition
Employee stock options that receive favorable tax treatment — no regular income tax at exercise, with gains potentially qualifying as long-term capital gains if holding requirements are met.
Incentive stock options are a form of equity compensation that can provide significant tax advantages over non-qualified stock options. When you exercise an ISO, you don't owe regular income tax on the difference between the exercise price and the fair market value — this "bargain element" is not taxed until you sell the shares.
To receive the favorable tax treatment, you must hold the shares for at least two years from the grant date and one year from the exercise date. If you meet both holding periods, the entire gain (sale price minus exercise price) is taxed as a long-term capital gain.
If you sell before meeting the holding requirements (a "disqualifying disposition"), the bargain element at exercise is taxed as ordinary income, similar to non-qualified options. This removes the main tax advantage of ISOs.
The critical caveat is the Alternative Minimum Tax. While the bargain element isn't included in regular taxable income at exercise, it is included in AMT income. Large ISO exercises can trigger substantial AMT liability, sometimes creating a tax bill even though you haven't sold any shares.
Strategic ISO management involves calculating the AMT impact before exercising, potentially exercising in stages across multiple years, and coordinating exercises with other tax events. Some employees exercise early in the year when the stock price is lower to minimize AMT exposure.
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Frequently Asked Questions
What's the difference between ISOs and NSOs for taxes?
ISOs have no regular income tax at exercise (but may trigger AMT). If you meet the holding periods, the gain is long-term capital gain. NSOs trigger ordinary income tax on the bargain element at exercise, regardless of when you sell.
Should I exercise my ISOs early?
Early exercise (when the bargain element is small) minimizes AMT exposure and starts both holding period clocks sooner. However, it requires paying the exercise price and risking the investment if the stock declines. Consult a tax advisor for your specific situation.