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Basics: Core Concepts

What is an incentive stock option?

While in general terms all stock options are a type of "incentive" compensation, an incentive stock option (ISO) is a specific type of stock option that qualifies for special tax treatment under the Internal Revenue Code if certain requirements and holding periods are met. This contrasts with nonqualified stock options, which do not qualify for this special tax treatment but, on the other hand, are not governed by as many as rules as ISOs.

Key facts to know about ISOs:

  • Section 422 of the Internal Revenue Code stipulates the conditions that must be met for an option grant to qualify as an incentive stock option.
  • When you exercise ISOs, no federal income-tax is withheld, and you do not owe Social Security and Medicare taxes.
  • After you exercise ISOs, if you hold the acquired shares for at least two years from the date of grant and one year from the date of exercise, you receive favorable long-term capital gains tax treatment for all appreciation over the exercise price when you sell the stock (see a related FAQ on ISO taxation).
  • ISOs are not granted by all companies and can be granted only to employees (not to outside consultants or contractors).
  • There is a $100,000 limit on the aggregate grant value of ISOs that may first become exercisable (i.e. vest) in any calendar year (see another FAQ for details).
  • To retain their tax benefits after a termination of employment, ISOs must be exercised within three months after you leave your job.
  • When you hold ISO shares through the calendar year of exercise, you can trigger the alternative minimum tax (AMT).
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