An ISO (incentive stock option) is a U.S. tax-qualified employee stock option granting potential capital gains treatment on appreciation if statutory holding periods and other IRS requirements are satisfied.

How it works

Companies grant ISOs through equity incentive plans approved by the board and stockholders. Only employees — not contractors — may receive ISOs. The alternative minimum tax (AMT) may apply at exercise if fair market value exceeds strike price, creating a cash tax bill before any sale. To obtain long-term capital gains on the full gain, holders typically must hold shares at least two years from grant and one year from exercise. ISOs face a $100,000 annual vesting limit for incentive treatment — amounts above vest as NSOs (non-qualified stock options) with ordinary income tax on spread at exercise. Early exercise of unvested options with 83(b) elections is a common startup strategy to start holding clocks. ISO tax treatment applies only for U.S. federal purposes; state rules vary.

Why it matters

• Founders / operators: Structure option grants thoughtfully — ISO vs NSO mix, early exercise availability, and 409A valuations affect hire competitiveness.
• Employees: Model AMT before exercising ISOs in private companies with rising 409A. Liquidity events trigger complex tax planning.

Common mistake

Exercising ISOs without understanding AMT liability on private company stock that cannot be sold to cover taxes.

Related ideas

NSO, 83(b) election, 409A valuation, equity incentive plan, and option exercise mechanics define startup employee equity.