Incentive Stock Options (ISOs): How They're Taxed and What to Watch For

Incentive Stock Options (ISOs) are a popular form of equity compensation, especially in startups and growth-stage companies. While they offer potential tax advantages, they also come with complex rules—particularly around timing, the Alternative Minimum Tax (AMT), and holding periods. Understanding how ISOs are taxed is key to maximizing their benefits and avoiding costly surprises.

What Are ISOs?

ISOs give employees the right to purchase company stock at a fixed price—called the exercise price—after a certain period, usually tied to a vesting schedule. If the stock price rises above the exercise price, you can buy shares at a discount.

Unlike Non-Qualified Stock Options (NSOs), ISOs may qualify for favorable long-term capital gains treatment, but only if you meet certain holding period requirements.

When Are ISOs Taxed?

ISOs are unique in that no regular income tax is due when they are granted or exercised—as long as you meet specific holding requirements. However, exercising ISOs may trigger Alternative Minimum Tax (AMT).

Let’s break it down.

1. At Grant

  • No tax is due when ISOs are granted.

2. At Exercise

  • No regular income tax is due at the time of exercise.

  • However, the difference between the fair market value (FMV) and the exercise price—called the bargain element—is treated as income for AMT purposes.

3. At Sale

  • If you hold the shares for at least 2 years from the grant date and 1 year from the exercise date, the entire gain is taxed as long-term capital gain.

  • If you don’t meet the holding periods, it’s called a disqualifying disposition, and part of the gain will be taxed as ordinary income.

Examples of ISO Tax Scenarios

Qualifying Disposition

  • Grant: Jan 1, 2022

  • Exercise: Jan 1, 2023

  • Sale: Feb 1, 2024

  • Outcome: All gain between exercise and sale is taxed as long-term capital gain.

Disqualifying Disposition

  • Grant: Jan 1, 2022

  • Exercise: Jan 1, 2023

  • Sale: June 1, 2023

  • Outcome: The bargain element (FMV at exercise - exercise price) is taxed as ordinary income. Any additional gain is taxed as capital gain (short- or long-term depending on holding period).

The AMT Trap

The Alternative Minimum Tax (AMT) is the biggest curveball in ISO taxation. The Alternative Minimum Tax (AMT) is a parallel tax system designed to ensure that high-income individuals pay a minimum level of tax. While there’s no regular tax at exercise, the IRS considers the bargain element as income for AMT purposes. If large ISO exercises aren’t planned carefully, they can trigger a significant AMT bill—even if you haven’t sold the shares and don’t have cash to pay the tax.

How AMT Works with ISOs

  • AMT income = (FMV at exercise – exercise price) × number of shares

  • This amount may push your total income above the AMT exemption, causing you to owe AMT.

Planning ISO exercises near year-end, understanding AMT thresholds, and using AMT credit carryforwards are all important strategies to consider.

What Happens After a Disqualifying Disposition?

In a disqualifying disposition, the favorable tax treatment is lost. The bargain element is taxed as ordinary income, and the rest of the gain or loss is treated as capital gain or loss. This can happen if you sell shares too soon or are forced to sell due to a company exit, job change, or personal need.

International Considerations

If you worked or lived abroad during the ISO vesting or exercise period, additional sourcing and reporting issues may arise. Some countries do not recognize the ISO structure and may tax the benefit at exercise or vesting instead. Work with a tax advisor familiar with cross-border equity compensation to avoid double taxation.

For more details on the sourcing rules for ISOs, visit the Sourcing page of this website.

Planning Tips for ISOs

  1. Track your holding periods carefully to qualify for long-term capital gains.

  2. Model your AMT exposure before exercising large amounts of ISOs.

  3. Exercise incrementally over time to manage tax liability.

  4. Sell shares strategically, especially in years when your income is lower.

  5. Keep detailed records of grant dates, exercise dates, FMV at exercise, and sale dates.

  6. Consider an 83(i) election (if available), which allows some deferral of income recognition on stock exercises for qualifying private companies.

Key Takeaways

  • ISOs offer favorable tax treatment if holding requirements are met.

  • No regular tax is due at exercise, but the AMT may apply.

  • Selling too soon results in ordinary income on part of the gain.

  • Planning around AMT, timing, and cash flow is essential.

  • Cross-border employees may face additional complexities.

Navigating ISO taxation can be tricky, especially when combined with other equity awards or international mobility. At Zeisei Group, we specialize in equity compensation planning and work with professionals across the globe to make the most of their stock options. Contact us if you'd like personalized advice.