What are the ISO withholding rules?
Unlike with NQSOs, with ISOs there is no federal income-tax withholding at exercise (even with a same-day sale), and no Social Security and Medicare tax is owed or withheld. Other than Pennsylvania, states follow these same rules. This does not mean you have no taxable income at exercise or sale. Rather, income tax is paid either when the return is filed or through estimated tax payments.
Alert: You therefore need to plan for future taxes that you will owe with your return. Consider putting aside the taxes you will owe, and also think about whether you need to make estimated tax payments.
For an annotated diagram of what will appear on your W-2 after you exercise incentive stock options, see a related FAQ.
Past IRS Efforts To Tax ISOs
The IRS was interested in this topic in the early 2000s. In 2001, it proposed to withhold Social Security and Medicare taxes, starting in 2003, from the entire spread at purchase/exercise of ESPP and ISO shares. But in 2002 the IRS decided to delay this change. Fortunately, the American Jobs Creation Act specifically excludes ISO and ESPP gains at exercise or sale from income tax withholding and from FICA (Social Security and Medicare) and FUTA taxes. Accordingly, the IRS withdrew its proposed regulations in July 2005.