What are Incentive Stock Options (ISOs)?

Incentive Stock Options (ISOs), sometimes called statutory or qualified stock options, are a type of employee stock option that allows employees to purchase company shares at a predetermined strike price.

ISOs are only available to current employees. If you leave the company, you typically have 90 days to exercise your vested ISOs. If you miss that window or receive an extension, your ISOs will usually convert to Non-Qualified Stock Options (NSOs).

ISOs vs NSOs

The two main types of employee stock options are ISOs and NSOs. They differ in two key ways:

1. Who they’re offered to – ISOs can only be granted to employees; NSOs can be granted to advisors, contractors, and board members.
2. How they’re taxed – ISOs may qualify for favorable tax treatment under the Alternative Minimum Tax (AMT), while NSOs are taxed as ordinary income at exercise.

With ISOs:

• No ordinary income tax is due at exercise (but AMT may apply)
• If held long enough, profits are taxed as long-term capital gains

With NSOs:

• The spread between the strike price and Fair Market Value (FMV) at exercise is taxed as ordinary income
• Any additional gains after exercise are taxed as capital gains

This gives ISOs two major tax advantages:

• Potentially lower AMT rate at exercise
• Larger gains eligible for long-term capital gains treatment

However, the IRS limits the amount of ISOs that can become exercisable each year to $100,000 (based on strike price). Anything above this converts to NSOs. The 1-year cliff common in startup equity grants often causes more than $100K worth of options to vest at once, triggering this limit.

ISO Expiration Rules

ISOs must be exercised within 90 days of leaving a company to retain their favorable status. Any extensions beyond 90 days typically convert them to NSOs. Some companies offer NSO extensions as part of severance or negotiated packages, allowing more time to exercise, but at the cost of ISO tax benefits.

Tax Implications of Exercising ISOs

ISOs offer tax advantages, but only if specific conditions are met.

When you exercise ISOs, there’s a spread between your strike price and the FMV of the shares. This spread is:

• Not taxed as ordinary income at exercise
• Included in AMT income, which may trigger an AMT liability the following tax season

The likelihood of owing AMT depends on the size of the spread and your income. You can estimate potential AMT using the ESO AMT Calculator.

What if you sell in the same year?

If you exercise and sell in the same tax year, it's a disqualifying disposition:

• The spread between strike price and sale price is taxed as ordinary income
• You are not subject to AMT on the exercise
• No payroll taxes apply

What if you sell after the year of exercise?

If you sell after December 31 of the year you exercised, AMT may apply.

• If the shares are sold within one year of exercise or within two years of grant, it’s still a disqualifying disposition → ordinary income tax and AMT may both apply (double taxation)
• If the shares are sold after one year from exercise and two years from grant, it’s a qualifying disposition → long-term capital gains on the full spread between strike price and final sale price

Other ISO Tax Notes

• ISOs are not subject to payroll taxes (like Social Security or Medicare).
• If you owe AMT, you may be eligible for an AMT credit in future tax years. Learn how AMT credits work →

Avoiding ISO Tax Pitfalls

Exercising ISOs can trigger large tax bills if not carefully planned. That’s why many startup employees:

• Exercise early while the spread is low
• Use AMT calculators before making decisions
• Partner with firms like ESO Fund to cover the cost of exercise without risk

Have questions or need help figuring out the tax impact of exercising your ISOs? Reach out to us. We’re happy to help, even if you don’t need funding.

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