Definition
A type of employee stock option that receives preferential tax treatment under federal law, with no ordinary income tax at exercise—but with potential Alternative Minimum Tax consequences.
Incentive Stock Options, or ISOs, are stock options granted by an employer that qualify for special treatment under the federal tax code. Unlike nonqualified stock options, which trigger ordinary income tax at exercise, ISOs generally produce no regular income tax when exercised. Instead, tax is deferred until the underlying shares are sold, and if certain holding periods are met the gain may be taxed at long-term capital gains rates rather than ordinary income rates.
The catch that surprises many recipients: the spread at exercise—the difference between the option's strike price and the stock's fair market value—is an AMT preference item. In a year when a large ISO exercise occurs, a family may owe significant AMT even though they received no cash and may not yet be able to sell the shares. This creates a cash-flow problem that can be severe if the stock later declines before sale. Careful planning around the timing and size of ISO exercises is therefore important at higher wealth levels, as discussed in resources like Wealth at $25 Million.
A hypothetical software engineer who joins an early-stage company, receives ISOs, and exercises them just before an IPO lockup expires might face a large AMT bill due before she can sell shares. A common confusion is conflating ISOs with QSBS; they are separate regimes that can overlap but have different requirements and benefits. A CPA and attorney familiar with equity compensation must evaluate any specific ISO exercise strategy.
Last reviewed August 25, 2026 · Editorial Policy
