Incentive Stock Options (ISOs)
Definition
A type of stock option that qualifies for favorable tax treatment under IRS rules. ISOs are only available to employees (not contractors or advisors). If you meet specific holding requirements — hold shares for 2 years from grant date and 1 year from exercise date — your profit is taxed at the lower long-term capital gains rate instead of ordinary income.
Real-World Example
You exercise 5,000 ISOs at $2 strike price when the FMV is $10. If you hold the shares for over a year after exercise and over two years from grant, you pay long-term capital gains tax (~15-20%) on the $40,000 profit instead of ordinary income tax (~22-37%).
Common Mistake
Forgetting about AMT (Alternative Minimum Tax). When you exercise ISOs, the spread between strike price and FMV is an AMT preference item. Many employees get a surprise tax bill in April after exercising ISOs, even though they have not sold any shares.
Why It Matters
ISOs can save you tens of thousands of dollars in taxes if managed correctly. But the AMT trap catches many people off guard. This is the single most important equity tax concept for startup employees.
Related Terms
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