Key Takeaways:

What are Incentive Stock Options (ISOs)?

Incentive Stock Options (ISOs), sometimes called statutory or qualified stock options, are a type of employee stock option that allows employees to purchase company shares at a predetermined strike price.

ISOs are only available to current employees. If you leave the company, you typically have 90 days to exercise your vested ISOs. If you miss that window or receive an extension, your ISOs will usually convert to Non-Qualified Stock Options (NSOs). Understanding the rules around ISO holding, how they're managed before and after exercise, is key to maximizing their value.

ISOs vs NSOs

The two main types of employee stock options are ISOs and NSOs. They differ in two key ways:

1. Who they’re offered to – ISOs can only be granted to employees; NSOs can be granted to advisors, contractors, and board members.
2. How they’re taxed – ISOs may qualify for favorable tax treatment under the Alternative Minimum Tax (AMT), while NSOs are taxed as ordinary income at exercise.

With ISOs:

• No ordinary income tax is due at exercise (but AMT may apply)
• If held long enough, profits are taxed as long-term capital gains

With NSOs:

• The spread between the strike price and Fair Market Value (FMV) at exercise is taxed as ordinary income
• Any additional gains after exercise are taxed as capital gains

This gives ISOs two major tax advantages:

• Potentially lower AMT rate at exercise
• Larger gains eligible for long-term capital gains treatment

The $100,000 ISO Limit

However, the IRS limits the amount of ISOs that can become exercisable each year to $100,000 (based on strike price). Anything above this converts to NSOs. The 1-year cliff common in startup equity grants often causes more than $100K worth of options to vest at once, triggering this limit.

Example:‍

You are granted 60,000 ISOs with a $10 per share strike price and a 4-year standard vesting schedule. When you hit your 1-year cliff and vest 25% of your options, you are vesting 15,000 options with a $10 strike price. This is equal to $150,000 of options (15,000 options * $10/share).

Since only $100,000 are allowed to vest as ISOs in a single year, you will vest 10,000 ISOs and the remaining 5,000 options will automatically convert and vest as NSOs. Any other shares that vest monthly in that calendar year will also convertto NSOs.

If your strike price was $1 instead, and you vested 15,000 options (15,000 options* $1/share = $15,000), you would simply vest all 15,000 as ISOs, as this amount is well below the $100,000 limit.

Understanding this limit is crucial for planning your exercise strategy and managing your tax liability.

ISO Expiration Rules

ISOs must be exercised within 90 days of leaving a company to retain their favorable status. Any extensions beyond 90 days typically convert them to NSOs. Some companies offer NSO extensions as part of severance or negotiated packages, allowing more time to exercise, but at the cost of ISO tax benefits.

Holding Period Rules for ISOs

Beyond the typical 90-day exercise window when leaving a company, the length of time you hold your ISOs, both before and after exercise, is crucial for determining their tax treatment. To qualify for the most favorable long-term capital gains tax rates, you must satisfy specific holding period requirements:

1. At least two years from the ISO grant date: You must hold your shares for at least two years from the date your company originally granted you the ISOs.
2. At least one year from the ISO exercise date: You must hold your shares for at least one year from the date you actually exercised (purchased) them. This aligns with the standard one-year holding period generally required for long-term capital gains on most stock.

If you sell your ISO shares before both of these holding periods are met, the sale is considered a "disqualifying disposition." This means that your gains will be taxed as ordinary income, rather than at the lower long-term capital gains rates. Meeting these holding periods is the key to maximizing the tax advantages of your ISOs.

Understanding Your ISOs: A Practical Example

To illustrate how Incentive Stock Options work and their tax implications, let's follow a hypothetical employee through a common startup equity journey from grant to exit.

Option Grant:

• Number of ISOs: 10,000 (for simplicity)
• Strike Price: $1 per share
• 409A Fair Market Value at time of exercise: $10 per share
• Sale Price: $20 per share

Tax Implications of Exercising ISOs

When this employee exercises their ISOs, they pay the $1 strike price per share. However, the difference between this strike price and the current FMV of the shares (determined by a 409A valuation) is considered a "phantom gain" by the IRS.

Let's calculate the tax impact for this hypothetical exercise:

• Cost to exercise: 10,000 shares * $1/sh = $10,000
• Fair Market Value of shares at exercise: 10,000 shares * $10/sh = $100,000
• Phantom Gain (Spread): $100,000 FMV- $10,000 Exercise Cost = $90,000

This $90,000 phantom gain is not taxed as ordinary income at exercise. Instead, it is included in the hypothetical employee's Alternative Minimum Tax (AMT) income, which could trigger a significant AMT liability the following tax season. The exact AMT owed depends on the employee's overall income, deductions, and specific tax situation. You can estimate potential AMT using our ISO AMT Calculator.

Tax Implications for ISOs at Sale: Different Scenarios

The tax impact when selling shares changes significantly depending on when you sell your exercised ISO shares relative to the exercise date and grant date.

Scenario 1: Exercising and Selling in the Same Tax Year (Disqualifying Disposition)

If the hypothetical employee exercises their 10,000 ISOs (at a $1 strike) and immediately sells them in the same tax year at $20 per share, say in a secondary sale or tender offer:

• Total Sale Proceeds: 10,000 shares * $20/share = $200,000
• Total Cost to Exercise: 10,000 shares * $1/share = $10,000
• Total Gain: $200,000 - $10,000 = $190,000

In this specific disqualifying disposition (because the holding periods are not met), the entire $190,000 gain would be taxed as ordinary income, at the employee's regular income tax rates for that year. This employee would generally not be subject to AMT on the exercise itself in this scenario, and no payroll taxes would apply.

Scenario 2: Holding Period Missed, Sold After Exercise Year (Disqualifying Disposition)

If the hypothetical employee sells their 10,000 ISO shares (exercised at $1 strike, with a $10 FMV at exercise) for $20 per share, but misses either the one-year-from-exercise or two-years-from-grant holding period:

• Total Sale Proceeds: $200,000
• Total Cost to Exercise: $10,000
• Total Gain: $190,000

In this case, the $90,000 "phantom gain" (spread at exercise: $10 FMV - $1 strike) would be taxed as ordinary income. Any additional gain beyond the FMV at exercise (in this employee's case, $20 sale - $10 FMV = $10 per share, or $100,000 total) would be taxed as capital gains. This post-exercise gain would be Short-Term Capital Gain (STCG) if the shares were held for less than one year after exercise, or Long-Term Capital Gain (LTCG) if held for more than one year after exercise (but still within two years from grant). Any AMT paid at exercise in a prior year would generate an AMT credit, but its recoupment would depend on future tax situations.

Scenario 3: Holding Periods Met (Qualifying Disposition)

If the hypothetical employee sells their 10,000 ISO shares (exercised at $1 strike) for $20 per share, and successfully meets both the one-year-from-exercise and two-years-from-grant holding periods:

• Total Sale Proceeds: $200,000
• Total Cost to Exercise: $10,000
• Total Gain: $190,000

In this qualifying disposition, the entire $190,000 gain (from the $1 strike price to the $20 sale price) would be taxed at the lower long-term capital gains rates. Any AMT paid at exercise in a prior year would generate an AMT Credit, which could potentially be used to offset future regular tax liabilities, making the overall tax burden significantly lower.

Important Note on AMT Credits

The Alternative Minimum Tax (AMT) you may owe at ISO exercise is often described as "frontloaded" or a "prepayment." While it generates an AMT Credit that can be used in future tax years to offset your regular tax liability, it's crucial to understand that recouping these credits isn't always immediate or guaranteed in every scenario. If you cannot fully utilize these credits (e.g., due to a quick sale at a lower price, or insufficient future regular tax liability), it can effectively result in a higher overall tax burden. Learn how AMT credits work →

Avoiding ISO Tax Pitfalls

Exercising ISOs can trigger large tax bills if not carefully planned. That’s why many startup employees:

• Exercise early while the spread is low
• Use AMT calculators before making decisions
• Partner with firms like ESO Fund to cover the cost of exercise without risk

What if exercising my ISOs is too expensive?

For many startup employees, the upfront cost of exercising ISOs, especially with federal taxes and potential AMT, can be prohibitive. It's a significant amount to pay out-of-pocket, and putting personal savings at risk for an uncertain future exit can be daunting. So, what do you do if you still want to unlock those potential tax savings or face an exercise deadline?

This is where ESO Fund's Risk-Free Option Exercise Funding can help. We provide a solution to cover 100% of your exercise costs (including taxes), allowing you to hold onto your shares and benefit from future gains without upfront financial strain or personal risk.

Here’s how ESO Fund's stock option exercise funding works:

• We cover 100% of your exercise costs (including strike price and taxes).
• You pay us back only after your company exits (IPO or acquisition).
• It’s non-recourse, meaning you don't risk your personal assets. If the exit never happens, you won’t have to pay us back.
• You remain the owner of your shares – you're not selling them to us.
• We make money only if there is a successful exit. In that case, you'll pay us back a portion of your proceeds. If there's no exit, you don't owe us anything.

Have questions or need help figuring out the tax impact of exercising your ISOs? Reach out to us. We’re happy to help, even if you don’t need funding.

Written by Jordan Long, Marketing Lead at ESO Fund