Financial Glossary
Incentive stock options (ISO)
Incentive stock options (ISOs) are a type of equity compensation granted exclusively to employees of a corporation (not consultants or directors who are not employees) that carry preferential federal income tax treatment if specific holding requirements are met. Under an ISO, no regular income tax is owed at grant or exercise; tax is deferred until the underlying shares are sold. If the employee holds the shares for at least two years from the grant date and one year from the exercise date (the qualifying disposition holding periods), the gain at sale is taxed as long-term capital gains rather than ordinary income. Exercising ISOs may trigger Alternative Minimum Tax (AMT) in the year of exercise, even before sale, based on the spread between exercise price and fair market value.
Problem & Application
An employee receives an ISO grant to purchase 10,000 shares at an exercise price of $1 per share. Three years later, when the stock is worth $6 per share, she exercises all 10,000 options. She pays $10,000 in exercise costs and receives shares worth $60,000 -- a $50,000 spread. No regular income tax is due at exercise, but the $50,000 spread is an AMT preference item and may generate an AMT liability depending on her overall tax situation. She holds the shares for 14 more months (satisfying the one-year post-exercise requirement) and sells at $8 per share for $80,000. Her long-term capital gain = $80,000 minus $10,000 cost basis = $70,000, taxed at preferential rates rather than ordinary income rates. Proper ISO planning -- including timing of exercise and assessing AMT exposure -- is a key service in startup-focused advisory engagements.
In Short
ISOs offer employees an attractive way to benefit from company growth, but both employees and employers need to understand the tax implications and structure the options properly.