Incentive Stock Options (ISOs)
Tax-advantaged stock options for employees that qualify for long-term capital gains treatment.
Definition
ISOs are stock options that receive favorable tax treatment under IRS rules. If you hold the shares for at least 1 year after exercise and 2 years after the grant date, the profit is taxed as long-term capital gains (lower rate) instead of ordinary income. However, the spread at exercise can trigger Alternative Minimum Tax (AMT). ISOs can only be granted to employees, not contractors, and have a $100K annual vesting limit.
Why it matters
ISOs can save you significant money on taxes compared to NSOs. But the AMT trap is real: if you exercise ISOs when the spread is large, you may owe AMT on paper gains even though you cannot sell the shares. Plan carefully with a tax advisor.
Example
You exercise 10,000 ISOs at a $2 strike when FMV is $12. The $100K spread ($10 x 10K) is an AMT preference item. If you hold the shares and sell 2+ years later at $25, you pay 20% long-term capital gains on the $230K total gain instead of 37% ordinary income.