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Daily Capital

What Are Incentive Stock Options (ISOs)?

Stock options are one of the more popular forms of equity compensation. They give employees the opportunity to buy company stock at a built-in discount while also possibly enjoying tax advantages.

There are two types of stock options, Incentive Stock Options (ISOs) and Non-statutory Stock Options (NSOs). Which type you hold will largely dictate your strategy around holding, exercising, and selling your stock.

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Employee equity can be complicated. Solid planning can help capture profits and reduce risk.”

JJ Lester, CFP®

Personal Capital Options Specialist

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In this article, we’ll focus primarily on ISOs. Also referred to as qualified stock options, ISOs can be granted only to employees of a company (independent contractors are not permitted).

While many people get excited about options and what their value might mean for their financial future(s), it’s good to remember there are certain strategies you can either implement or avoid to ensure you are getting the outcome you desire.

For a deeper understanding of employee equity, you can download our free equity compensation guide. Once downloaded, you unlock access to Personal Capital’s financial tools, and with these two free resources, you’ll be able to:

  • Calculate the value of your equity
  • Understand the potential tax treatment of your compensation
  • Weigh your options on cashing out

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Understanding ISOs

With an ISO, employees are allowed to purchase company stock at a predetermined price (known as the exercise price) for a set period of time. If the current market price is higher than the exercise price, the options have value. But if the current market price is lower than the exercise price, the options have no value and are considered to be “underwater.”

ISOs are typically valued on the grant date, and employees can choose when to exercise their right to buy them. Once the options are exercised, they begin their holding period. Depending on the company, employees can hold and sell later, may be required to hold until a liquidity event, or may be able to sell immediately. Stock options also feature an expiration date — if they aren’t exercised before this date, they vanish.

In most instances, ISOs are subject to a vesting period; employees must wait until the options have vested before they can exercise them. The most common vesting schedule is annual vesting. For example, on a five year vesting schedule, employees vest one-fifth of their options each year.

Employees can pay cash upfront to exercise their ISOs or sometimes use a cashless exercise, which sells some options in order to exercise others. A cashless exercise can be a useful way to exercise some options when the actual cash exercise cost is too high.

Companies don’t always offer ISOs due to their complex tax treatment, but when they do, ISOs can bring special tax benefits to employees.

Tax Treatment of ISOs

ISOs potentially have more favorable tax treatment than other types of employee equity compensation as long as certain requirements are met.

If you hold the shares longer than two years from grant and one year from exercise, you could qualify for preferential long-term capital gains treatment upon sale. If you don’t meet this requirement, then the sale will be treated as a disqualifying disposition and gains are treated as ordinary income.

While ISOs are not taxed for regular tax purposes until they are sold (if you meet the holding requirements), the alternative minimum tax (AMT) may apply if you exercise and hold the shares past year-end. The bargain element (the difference between the grant price and the exercise price) is considered AMT income in the year that you exercise your ISOs.

But AMT doesn’t have to be the end of the world, as long as you can afford to pay it. It’s not an extra tax as much as it’s an acceleration of tax you would have to pay anyway.  If you pay AMT after exercising options, you may be entitled to an AMT tax credit that can be used to lower your tax bill in subsequent years. It’s advisable to speak with your tax advisor or CPA to understand if this is applicable to you.

How to Exercise ISOs

ISOs can be a bit trickier to exercise than NSOs because tax consequences depend on how long you hold the shares.

If you hold on to your shares for the qualification period (two years after grant, one year after exercise) and things go well, then you will likely only owe long-term capital gains tax when you sell. You may, however, still need to put up a sizable amount of cash upon exercise, both to purchase the shares and pay any AMT if it applies. And it’s possible your stock’s value could just as easily go the other way, which means you would erase any potential gains – and in some cases, may have to pay out of pocket to cover taxes.

Our Take

Understanding the value of your ISOs, their vesting requirements, and your exercise strategy are crucial elements of a successful financial plan around employee equity. Next steps for you?

  1. Learn more with Personal Capital’s free guide to employee equity compensation.
  2. Consider speaking with Personal Capital’s dedicated financial advisors, who can help sort through the oftentimes complex circumstances surrounding employee equity compensation.

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The content contained in this blog post is intended for general informational purposes only and is not meant to constitute legal, tax, accounting or investment advice. You should consult a qualified legal or tax professional regarding your specific situation. Keep in mind that investing involves risk. The value of your investment will fluctuate over time and you may gain or lose money.

Any reference to the advisory services refers to Personal Capital Advisors Corporation, a subsidiary of Personal Capital. Personal Capital Advisors Corporation is an investment adviser registered with the Securities and Exchange Commission (SEC). Registration does not imply a certain level of skill or training nor does it imply endorsement by the SEC.

Shannon Lynch is a Senior Financial Advisor at Personal Capital, where she provides holistic financial planning services for individuals and families. Prior to joining Personal Capital, she was a Registered Client Service Associate at UBS Financial Services in both Seattle and San Francisco and worked with a number of different advisors and teams, including the San Francisco Equity Compensation Group. She received her bachelor’s degree from University of Washington with a double major in Economics and Political Science. Shannon is a CFP® professional.
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