Incentive Stock Options (ISO)

As a form of compensation, some companies issue stock options to employees. Incentive Stock Options (ISO), or Nonqualified Stock Options (NSO) is the general form which these stock options take. For preferential tax treatment, ISO's must satisfy the conditions of the Internal Revenue Code, so they are more restrictive than NSOs. For example, ISOs cannot be granted at a discount to the current stock price as Nonqualified Stock Options can. However, Incentive Stock Options can only be granted to employees On the grant date, and the exercise price cannot be lower than the fair market value of the stock. Except through a will, these options cannot be transferred to another person.

When the options are granted, income tax is not charged when they are exercised, the employee pays no tax. Income tax for the employee is deferred until after the employee sells the stock obtained through the exercise of the options, with these above mentioned options. As long as the stock is held at least one year after exercise of the options and at least two years after they are granted, Capital gains are taxed as long term gains. Otherwise, the subsequent gain after the exercise is taxed as short term capital gains and the gain at exercise is taxed as ordinary income. The difference between the option exercise price and the stock value at the time of option exercised, is what measures the gain at exercise. Favorable tax treatment is lost if the Incentive Stock Option is exercised more than three months after the employee has left employment at the company which granted the options.

Although there is no federal income tax at the time of exercise, the paper gain at exercise is subject to the alternative minimum tax (AMT) when an ISO is exercised and held, but this is merely a prepayment of tax, which will be credited back by the IRS at final disposition of the sale of the stock obtained when the option is exercised.