For all capital gains at sale to be taxed at favorable long-term rates, you must hold your ISO shares for at least two years from the date of your option grant and at least one year from the date of option exercise. The full gain over the exercise price is then all capital gain.
Example: Your exercise price is $22 and the market price on the date of exercise is $30 (the $8 spread is part of the AMT calculation). You sell the ISO stock at $40, after holding the stock for more than one year from exercise and two years from grant. You have $18 in capital gains at sale ($40–$22) to report on your tax return, with no ordinary income. You also have an AMT adjustment at sale if your exercise triggered the AMT.
If you do not meet these requirements (i.e. you make a disqualifying disposition), the ISOs will be taxed more like NQSOs and therefore lose the potential for special tax benefits. The timeline below illustrates the concept of the holding period, showing how long you must keep the shares to prevent a disqualifying disposition and make a qualifying disposition at sale.
Since most stock option grants at public companies have a vesting period of at least one year, it is your post-exercise holding period that usually determines the tax treatment (explained in other FAQs and articles on this website).
Pre-IPO companies sometimes grant ISOs that are immediately exercisable by employees into stock, subject to a company repurchase right should you leave before they vest. While the same rules for the ISO holding periods apply from grant and exercise, if you make a disqualifying disposition of pre-IPO stock, your compensation income is based on the stock value at the vesting date (not the exercise date), and your holding period for capital gains begins upon vesting (not at exercise).