Introduction to the Incentive Stock Option (ISO)

Incentive Stock Options (ISOs) are just one of many employer sponsored equity programs we’ll be covering the in’s and out’s of, especially as it relates to the AMT

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Quick Summary

  • ISOs are a great form of compensation with very little risk and potential upside
  • ISOs are very similar to regular stock options, but differ in how they are treated at time of the sale (qualified or disqualified dispositions)
  • In addition, exercising Incentive Stock Options may trigger the Alternative Minimum Tax
  • To potentially save thousands of dollars on taxes, it is always best to plan out when to exercise your ISOs with our AMT Calculator AMT Calculator

Stock Options - The Basics

Just to make sure we’re all on the same page, let’s cover some lingo commonly used when discussing any stock options as it’ll be important in understanding this article, but also in knowing what to input when filing your taxes or using an AMT Calculator AMT Calculator

  • An Option is essentially like a promise. It grants you the ability to Exercise (buy or sell) a certain stock at an agreed upon price sometime in the future. This price is called the strike price.

  • For the purposes of an ISO, Exercising An Option just means to ‘pay money to buy and convert the option to a real stock that you now own’. The date that you exercise an option is called the Exercise Date.

  • The Fair Market Value (FMV) of a stock is what it would sell for on the open market, all things considered. The FMV is calculated based on a variety of financial inputs. When you exercise an ISO, the fair market value of the stock is recorded, even if your company is currently not yet a public company and listed on a stock exchange.

For a publicly traded company, the FMV is not always the share price on the market. Think of the FMV as a theoretical number.

  • After you’ve exercised an option, which is now a stock, you can choose to sell it like any other asset. The price you sell the stock at is the Sale Price.

ISO Specific Terminology

In addition to the above, there are a few other pieces of terminology relevant to Incentive Stock Options:


You would typically receive ISOs as part of a compensation package for working at a company. The ‘batch’ of ISOs promised to you is typically called an Equity/ISO Grant or Award.

Each grant will come with a set strike price for those options, as well as a Grant / Award Date, which is literally the date in which the grant is legally assigned to you. Throughout your tenure at a single company, you can receive multiple grants of options, each with different grant dates and possibly different strike prices.


The action of vesting means for options to actually become yours, almost like they are being ‘released’ to you. This is important because although you may have an ISO grant, not all the options in that grant are actually yours until they vest. It’s similar to your salary. When you start a job, you are promised to be paid a certain dollar amount for a year of work. If you only work half a year and leave, you would only end up getting half the salary promised.

In a similar vein, ISO grants all come with some sort of Vesting Schedule which is, as you may have guessed, the terms and timeframe in which the options will vest. Typical vesting schedules are over 3-5 years, to incentivize employees to stay at a company.

Within a vesting schedule you’ll often see terms such as a ‘4 year quarterly vesting period with a 1 year Cliff’. This means that every quarter that you are employed, options will vest (and become yours) except for the first year, where you will receive nothing until after your first entire year of employment (the cliff). This is extremely common as to avoid folks joining a company, vesting a handful of shares, and jumping ship.

The date when a set of options vest is your Vesting Date. As you can imagine, options in one grant will have many different vesting dates. Don’t worry, your company’s financial institution provider should track all of this.

You can have vesting schedules on a variety of intervals (monthly, quarterly, per paycheck) and some can be unevenly distributed (i.e. front or backloaded).

Many companies also offer grants as part of promotion / review cycles. These subsequent grants often do not have any cliffs as you’ve supposedly already ‘proven your loyalty’ by staying for some duration.

Tax Implications of ISOs

When you exercise an ISO, you will need to report it when filing for taxes. This is probably why you’re here! Apart from impacting your regular income tax, exercising ISOs is one of the few things that trigger the Alternative Minimum Tax, which is a completely separate tax system which oftentimes can lead to you having to pay additional taxes in a given year. We have a few articles that cover the basics of the AMT

Although you are not taxed immediately, you are going to be ‘double taxed’ on any ISO. Once on the exercising of the option, and the second time on the sale of the stock (as a capital gain).

And even though this seems particularly unfair, it works similarly to your income tax. You get taxed on your wages, and if you were to choose to buy stocks and sell them, you would be taxed on that as well - there’s just a different system for this calculation - the AMT.

But wait, there’s more

In addition, the sale of a stock that was from exercising an ISO is subject to an additional special set of rules! You can read about what a disposition is and the differences between a qualified and disqualified disposition here