Incentive stock options (ISO)

What are incentive stock options?

Incentive stock options (ISO) are a type of equity compensation that give employees the right to purchase company stock at a predetermined price, known as a strike price or exercise price. ISOs are required to be granted with an exercise price at or above the fair market value (FMV) of the company’s common stock on the grant date, making them a popular form of compensation at startups and other fast-growing companies. ISOs are a type of stock option, and are not actual shares of stock. You must exercise your options to become a shareholder.

For employees, ISOs offer the opportunity to purchase shares at a set price, allowing them to take advantage of the stock’s appreciation over time. This gives an employee the ability to share in the success of a growing company. Unlike other types of options, ISOs also offer significant tax advantages to employees if certain conditions are met. 

For companies, ISOs are a cost-effective way to attract, motivate, and retain talent with competitive compensation packages outside of base pay and bonuses. ISOs are also structured with vesting schedules, which creates a long-term incentive for employees to stay with the company and fully realize the value of their equity compensation.

Important terms to know:

• Grant date: The date an employee or service provider is granted options

• Strike price: The fixed price at which an employee can purchase shares

• Vesting schedule: The timeline defining when ISOs can be exercised

• Holding period: The time required for ISOs to qualify for favorable tax treatment

• Exercise date: The date on which an employee purchases shares by exercising ISOs

ISO tax treatment

There are two types of taxes to consider with incentive stock options: ordinary income tax and capital gains tax. The capital gains tax rate has historically been lower than the ordinary income tax rate.

→Learn more about how stock options are taxed

Qualifying disposition

When you exercise ISOs, you don’t have to sell the resulting shares right away. If you exercise ISOs and hold your stock for at least one year after purchase and two years after grant, your stock should be eligible for favorable tax treatment when you sell and you will pay the lower capital gains tax rate on the increase in value. However, you may be subject to the alternative minimum tax (AMT) when you exercise.

The alternative minimum tax and ISOs

The alternative minimum tax (AMT) is a separate way of calculating tax liability to make sure taxpayers, especially high earners, pay an appropriate amount of federal income taxes. If you exercise ISOs but don't sell the shares in the same year, the difference between the strike price and the value at the time of exercise is treated as income when calculating AMT. However, if you exercise and sell the shares within the same year, this spread is not included in AMT income but is instead treated as regular income. Talk to your tax advisor to see if AMT might impact you. Typically, it only affects high-income earners.

→Learn more about the alternative minimum tax

The $100K ISO limit

The $100K ISO limit restricts employees from receiving favorable tax treatment on more than $100,000 worth of incentive stock options that become exercisable for the first time within a single year.

→Learn more about the $100K ISO limit.

Disqualifying disposition

If you do sell shares exercised from ISOs right away (for example, to cover the cost of exercise), the shares you sell won’t qualify for favorable tax treatment or advantages. Instead, they’ll be taxed like non-qualified stock options (NSOs), and you’ll pay ordinary income tax on the spread between your strike price and the FMV at the time of sale.

When can I exercise ISOs?

Usually, you can’t buy all of your shares right away and have to work for the company over time to be able to purchase your shares. This process is called vesting. You can exercise your ISOs as soon as your options have vested, but it’s not required.

In some cases, you might be able to exercise your ISOs before they vest. You can check your option grant or ask your company to see if they allow early exercising. Note that this may result in a taxable event, so also consult with your tax advisor.

→ Learn more about exercising stock options.

When do incentive stock options expire?

Theoretically, ISOs have an expiration date of 10 years from the date you’re granted them. However, your company might enforce a post-termination exercise (PTE) period that gives you a shorter amount of time to exercise options after you leave the company. If you don’t exercise them before that period ends or before they expire, you may lose the opportunity to purchase them.

Even if your company gives you a long time to exercise ISOs after you leave, if you don’t exercise them within three months of leaving, they’ll lose their ISO tax treatment and will be taxed like NSOs if you ultimately exercise them.

When can I sell my ISOs?

You have to exercise ISOs and purchase shares before you can sell your shares. If you choose to exercise your ISOs, you usually have two options: pay for the total in cash or do a “same-day sale”—in other words, sell a portion of your shares to cover the cost of exercise.

Selling to cover exercise costs is called a cashless exercise. It’s less risky because you haven’t invested your own money. However, selling shares right after exercising prevents you from taking advantage of ISOs’ favorable tax structure. Not all companies allow cashless exercises, so check to see if yours does before exercising and check with your tax advisor in general.

Incentive stock options vs. non-qualified stock options

Non-qualified stock options (NSO) are another type of stock options U.S. companies may offer to employees. With NSOs, you pay taxes both when you exercise and sell your options. This usually means you pay more taxes with NSOs than with ISOs.

ISOs vs. NSOs

ISOs vs. equity awards

Instead of stock options, some startups use alternative equity compensation, such as restricted stock awards (RSA) or restricted stock units (RSU), depending on the company’s stage. RSAs are typically used for very early stage companies, while RSUs are common for more mature ones. Both RSAs and RSUs are grants of stock, not options of stock, so you typically don’t need to exercise them.

→ Learn more about the differences between RSUs and stock options