What are Incentive Stock Options?

Incentive stock options (ISOs) are a type of stock option typically given to key employees or management to purchase stock in the company and can result in a better tax treatment.

Incentive Stock Options vs. Nonqualified Stock Options

Other options that may be available to employees who are not considered key employees or upper management may be eligible for nonqualified stock options or NSOs.

Unlike NSOs, an ISO would be treated favorably for tax purposes. When an ISO is exercised, the employee need not claim the income. When they sell the stock, the gains are taxed as ordinary income rates rather than at capital gains rates. It is important to be aware that the tax benefits are lost if the employee who is entitled to ISOs sells the stock immediately; if they sell immediately they are treated the same way as an NSO.

What's the difference between an ISO and an NSO?

There are several differences between ISOs and NSOs including who can own them. The following chart explains the primary differences:


Incentive Stock Options (ISOs)

Non-Qualified Stock Options (NSOs)

Can Be Issued To

May only be issued to employees.

Investors, honorary board members, employees; anyone may be given NSOs.


The board of directors and shareholders must have previously approved a stock option plan.

In most cases, there will be a written agreement andapprovalby the board of directors.

Exercise Price

The right to exercise at a certain price must be established. It may not be lower than the market value at the time the ISO is granted.

If the grant is given with an exercise price that is lower than the market value there are potential penalties imposed by the IRS under Section 409(A). The penalties could include taxing the options at the time they are vested.

Transfer and Exercising

An ISO cannot be transferred to another person. The period from the date of the grant to the exercise date may be no longer than 10 years. All must be exercised within three months of the person no longer being employed at the company; the exceptions are one year if the person leaves due to disability and no time limit if the person is deceased.


Exercise Price

When issued to a shareholder who owns 10 percent or more of the company, the exercise price must be 110 percent or more of the market value at the time of the grant.


Limits on Granted Value

If ISOs are granted to a shareholder who owns 10 percent or more of the company, the annual limit on the value on ISOs is $100,000 in stock value at the time of the grant. Any amount in excess of this is treated as an NSO.

There are no limits placed on the value of granted options for NSOs.

How Incentive Stock Options are Taxed

It is important to speak with a tax professional regarding the tax impact of incentive stock options. Both employers and employees may be facing tax benefits or penalties when issuing a grant, when selling stock and when exercising incentive stock options.

ISO Tax Impact on Employer

If an employee sells the stock before the necessary holding period the company may be entitled to a federal tax deduction. Otherwise there is no tax benefit.

ISO Tax Impact on Employee

Employees will not face a tax at the time they are granted incentive stock units nor at the time they exercise the option. However, they wll be facng a long term capital gain or loss at the time they sell the stock. The employee must hold the stock for a minimum of one year from the date of exercise which must be a minimum of two years from the date they were granted.

The alternative tax will apply to the amount of difference between the exercise price and the value of the stock at the time the option is exercised. The tax basis for incentive tax options is the gain or loss between the value of the amount the employee paid for the stock when the option was exercised and the amount they received from selling the stock.

Incentive Stock Options and the Alternative Minimum Tax (AMT)

When an employee exercises their options they may be paying less for the stock than the current market value. The difference between the share value on the date of exercise and the exercise price is subject to the AMT. It works like this:

Employee has the right to purchase 10,000 shares of stock at $10 per share. On the date of exercise the stock is trading at $50 per share. The employee would have to claim $4o per share x 10,000 shares as income or $400,000 which would be subject to the AMT. Anyone who is considering exercising shares and facing a gap between the exercise price and the market price is encouraged to discuss their options with a tax professional.

Frequently Asked Questions

  • Are incentive stock options taxable?

There are five different categories under which incentive stock options may be taxed; each working in as different matter. ISOs allow employees to:

  1. Exercise their option to purchase shares and hold the shares for sale at a later time.
  2. Exercise their option to purchase shares and sell them during the same year.
  3. Exercise their option to purchase shares and sell them during the following calendar year but less than 12 months after the exercise date.
  4. Exercise their option to purchase shares and hold them for one year and one day after purchase but less than two years since the original grant date.
  5. Exercise their option to purchase shares, sell them at least one year and one day after the purchase date and at least two years since the original grant date.

In each case, the transaction will be taxed differently. For most employees, the first and last will offer the most favorable tax result.

  • What do I do with Form 3921?

Employees should hold Form 3921 with their investment records. It will be needed later to establish the stock price on the date of the grant as well as the date of the exercise of the ISO.

Incentive Stock Options and Form 3921

Section 422(b) of the Internal Revenue Service code requires a company to provide each person who acquires stock after exercising an incentive stock option a Form 3921.

Form 3921 will contain the information about the employee including the date the option was granted, the share price on the date of the grant as well as the share price on the date the grant was exercised.

Additional Information

IRS Form 3921 Exercise of an Incentive Stock Option Under Section 422(b)

IRS Form 3922 Transfer of Stock Acquired Through an Employee Stock Purchase Plan Under Section 423(c)

AMT Assistant for Individuals

Form 6251 Alternative Minimum Tax – Individuals

Form 8801 Credit for Prior Year Minimum Tax - Individuals, Estates, and Trusts