Incentive Stock Option (ISO)
Also: ISO, incentive stock option, ISOs, qualified stock option
A tax-favored employee stock option governed by IRC Section 422. No regular federal income tax at exercise, but the spread is an AMT preference item. Long-term capital gains treatment is possible if holding periods are met.
An ISO is a stock option that meets the requirements of IRC Section 422 and is granted only to employees. Unlike NSOs, ISOs trigger no regular federal income tax at exercise. The bargain element, meaning FMV minus strike, is a preference item for the Alternative Minimum Tax. If the shares are held at least one year from exercise and two years from grant, the gain on sale is long-term capital gain taxed at 15% or 20%, plus NIIT where applicable.
Example: grant at a $5 strike, exercise at $45 FMV for 10,000 shares. The $400,000 spread creates no regular tax, but it feeds AMT and frequently triggers a tax bill of roughly $100,000 to $110,000 for a married filer. Selling within the same calendar year eliminates the AMT by creating a disqualifying disposition.
Common mistake: exercising a large ISO block in January and holding, without modeling AMT. A mid-year layoff or stock decline can leave the employee with a tax bill larger than the shares are worth.
ISOs matter at exercise, at sale, and in the AMT credit recovery years that follow. Plan the exercise calendar against AMT headroom and the 90-day post-termination window.