Takeaways
- ISOs give employees the right to purchase stock at a predetermined strike price.
- ISOs are a form of equity compensation offered to new and existing employees.
- ISOs are sold for short- or long-term capital gains, based on your holding period,
- ISOs are used to attract, incentivize, and retain highly talented employees.
- ISOs have better tax treatment than NSOs because you are only taxed when you sell incentive stock options.
As a high earner, you can completely revamp your personal finances. However, not all compensation comes from high salaries and bonuses. One of the fastest and best ways to earn more income quickly is through stock purchase plans and stock options, particularly for startups and tech company employees. One of the popular types of equity compensation is Incentive Stock Options (ISOs). ISOs stand out due to their favorable tax treatment and potential to earn significant capital gains over time.
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What Are Incentive Stock Options (ISOs)?
An Incentive Stock Option (ISO) is an employee stock option that provides tax advantages if certain conditions are met. ISOs are granted to new employees as part of their sign-on compensation package or to existing employees as an employee retention mechanism. In both cases, ISOs are used to compensate you and align your financial interests with the company’s long-term growth strategy.
Unlike Non-Qualified Stock Options (NSOs), ISOs have specific tax benefits but also come with strict regulatory requirements.
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ISOs are generally reserved for key employees and executives. They allow the ISO contract holder to purchase common stock at a predetermined price, known as the exercise or strike price. Employees can profit from the difference when selling their shares on the open market if the stock price exceeds the exercise price.
Tax Implications of ISOs
One of the main attractions of ISOs is the way they are taxed. Unlike other forms of compensation, ISOs are not taxed when granted or vested. However, taxation does come into play when you exercise an ISO.
At this stage, the difference between the exercise price and the stock's fair market value (FMV) on the exercise date is considered an Alternative Minimum Tax (AMT) preference item.[1]
This means that exercising ISOs may trigger the AMT, a separate tax calculation that applies to certain taxpayers and can result in additional tax liability. The IRS has a rule that employees cannot receive more than $100,000 worth of ISOs in a single year.[2]
The Internal Revenue Service created this rule to prevent employees and companies from taking advantage of ISO tax benefits.. Given the complexity of AMT calculations, employees exercising ISOs should consult a tax professional or financial advisor to optimize their tax strategy.
When to Exercise ISOs
Deciding when the best time is to exercise ISOs depends on several factors. If your company’s stock price is expected to increase, exercising your ISOs early could lock in a guaranteed gain (if you sell your shares). Before you exercise your options, you should seriously consider whether exercising ISOs will trigger AMT and try to minimize your tax burden. You don’t want to be surprised when you are filing your taxes.
Additionally, liquidity is a key consideration. Employees will need enough funds to cover the exercise cost and any potential taxes. When you exercise your ISOs, you must pay the exercise price for your awards.
ISO Exercise Example
Let’s say you have been awarded 1,000 ISOs with an exercise price of $2 per share. Your company’s stock is now trading at $50 per share. Because your stock options are “in the money,” you decide to exercise and sell your shares. You have a couple of options.
- Cash Exercise: If you decide to exercise and sell 1,000 ISOs, you must pay $2,000 to exercise your shares (1,000 X $2 per share). You will make a profit of $48,000 (50,000 – 2,000).
- Cashless Exercise: You can sell part of your awards to pay for the exercise price. In this scenario, you sell 43 shares (Fair Market Value of $50 per share - Exercise Price of $2 per share) X 43 shares = $2,000)) to cover your exercise costs. You will still make a profit of $48,000.
Why Exercise and Sell ISOs?
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Don’t Forget About Liquidity
Your company’s plans can influence the timing of when to exercise your ISOs. If you already work for a publicly traded company, then you should be able to exercise and sell your shares quickly.
But if you work for a private company, there are other items to consider. Your ISOs in a private company are illiquid, meaning there will be no active buyers because your company’s stock is not traded on a stock market.
It might be a smart money move to wait until your company is considering an Initial Public Offering or merging with a public company. Depending on the company’s status, you can consider exercising your ISOs in multiple tranches or stages to manage tax liability.
Why Companies Offer ISOs
ISOs attract and retain top talent by incentivizing employees to stay with the company and contribute to its long-term success. They also align employees’ interests with shareholders, as employees benefit from stock price appreciation, motivating them to support company growth.
Startups, in particular, use ISOs as a competitive compensation tool to attract top talent while preserving cash for essential business operations.
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Pros of ISOs
- Favorable Tax Treatment: If held for the required period, ISOs are taxed at long-term capital gains rates rather than as ordinary income. (Read about the Best Tax Software Programs).
- No Tax at Grant or Vesting: Unlike non-qualified stock options, you do not incur immediate tax liability when ISOs are granted or vest.
- Potential for High Returns: Employees can realize substantial financial gains if the company’s stock price increases significantly. (Read more about How Ordinary Income Works).
- No Immediate Out-of-Pocket Tax Cost: Unlike NSOs, where taxes are due at exercise, ISOs offer flexibility in tax planning. (Try these 5 Smart Money Saving Habits).
Cons of ISOs
- Alternative Minimum Tax (AMT) Impact: Exercising ISOs can trigger AMT, leading to unexpected tax burdens. (Read more about What Creates a Tax Liability).
- Risk of Stock Depreciation: Employees could lose money if the stock price falls after exercise. This dynamic could set you up to take advantage of tax-loss harvesting.
- Liquidity Challenges: Employees may need cash to exercise ISOs and cover taxes, but they might not be able to sell shares immediately. (Store your shares in one of the Best Online Stock Brokerage Accounts).
- Strict Holding Requirements: To qualify for favorable tax treatment, you must hold the shares for a specific holding period, which may not always align with your financial needs. A well-thought-out financial plan can help you map your finances and ensure you can take advantage of the favorable tax treatment.
Smart Summary
Incentive Stock Options are a form of equity compensation given to highly valued employees. With careful planning, they can be a powerful wealth-building tool for employees. Understanding their tax implications, knowing when to exercise them, and evaluating personal financial circumstances are key to maximizing their benefits. Companies use ISOs to attract and retain employees as incentives to inspire long-term growth. Read more in our Equity Compensation Guide.
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(1) Cornell Law School. Incentive Stock Options. Last Accessed March 13, 2025.
(2) Internal Revenue Service. Taxable and Nontaxable Income. Last Accessed March 13, 2025.
