Incentive Stock Options (ISOs)

What are Incentive Stock Options (ISOs)?

Incentive stock options are a form of equity compensation that give an employee the right to buy company stock at a fixed price, called the strike or exercise price, that’s set on the grant date. For ISOs, the strike price has to be at least the fair market value of the stock on the grant date, so you’re essentially locking in the company’s valuation at that point in time.

For example, someone may be granted 1,000 stock options that give them the ability to choose to buy (exercise) shares at $1 per share. Early on these are very speculative, but when the company grows close to what everyone anticipates, they can become very profitable. In this case, for every $1 the stock rises above the strike price, the employee can potentially realize $1,000 of economic benefit before taxes.

ISOs are most common at early-stage startups because of how lucrative they can become. As companies mature, they usually move away from them for two main reasons: the cash burden on employees, who have to pay to buy their shares, and the tax risk that comes with ISOs.

A few rules that make an option an ISO:

• ISOs can only be granted to employees, not contractors, advisors or outside board members.
• Only $100,000 worth of ISOs (based on the stock’s value on the grant date) can first become exercisable in any calendar year. Anything over that is automatically treated as a non-qualified stock option (NSO).
• If you leave the company, you generally need to exercise within three months of your last day to keep ISO treatment. If your plan lets you exercise later than that, those options are taxed as NSOs.

What is the tax risk with ISOs?

To understand the tax risks with ISOs, you need to understand the Alternative Minimum Tax (AMT). AMT is a second, parallel tax calculation that makes sure taxpayers who benefit from certain tax breaks still pay a minimum amount of tax. You calculate your tax under the regular rules, then again under the AMT rules, which add back certain items the regular system excludes, subtract an AMT exemption amount, and apply AMT rates of 26% and 28%. You pay whichever number is higher.

The most common thing that pushes people into AMT is exercising ISOs. When you exercise ISOs and hold the shares, the discount you received (the difference between what the shares are worth and what you paid, also called the “bargain element”) is excluded from your regular taxable income. AMT adds it right back.

Let’s take a look at the example from before. Someone has 1,000 fully vested ISOs with a $1 strike price. The stock is now worth $100 per share, so they exercise. They pay $1,000 and receive $100,000 worth of stock. Under the regular tax rules, nothing is taxable yet, because it’s a qualified stock option. But under AMT, the IRS sees that you received $99,000 of compensation, just like your salary.

Now say this person is single with a $50,000 salary in 2026:

Their regular federal tax is about $3,820. Under AMT it’s about $15,314. They owe the higher of the two, which means an extra $11,494 of tax on stock they haven’t sold, and in a private company may not even be able to sell.

Not only is that a surprise tax bill, but it’s your responsibility as the taxpayer to see it coming and make estimated payments or increase your withholding. If you don’t, and you’re not covered by one of the safe harbors (paying at least 90% of this year’s tax or 100% of last year’s, or 110% if last year’s AGI was over $150,000), the IRS charges an underpayment penalty at the federal short-term rate plus 3%. That’s 7% a year as of the fourth quarter of 2026, charged from each quarterly due date until you pay. If $10,000 of tax goes unpaid for a full year, that’s about $700 on top of the tax itself.

This matters even more starting in 2026. The AMT exemption now starts phasing out at $500,000 of AMT income for single filers ($1,000,000 for married filing jointly), and it phases out twice as fast as it used to. Large ISO exercises are more likely to trigger AMT than they were a year ago.

The good news is that AMT you pay because of an ISO exercise usually isn’t lost for good. It creates a minimum tax credit (Form 8801) you can use in future years when your regular tax is higher than your AMT, including the year you eventually sell the shares. But it can take years to recover, and it doesn’t help you pay the bill in April.

Why does the ISO holding period matter?

There’s an additional layer of tax risk because ISOs only get their preferred tax treatment if you hold the stock long enough: at least 2 years from the grant date and 1 year from the exercise date. If you meet both, it’s called a qualifying disposition, and the entire gain from your strike price to your sale price is taxed as long-term capital gain instead of ordinary income. That’s a maximum rate of 23.8% (20% plus the 3.8% net investment income tax) compared to 37% on ordinary income in 2026. On $100,000 of gain, reaching the holding period means you legally pay $13,200 less in tax.

If you sell before meeting both holding periods, it’s a disqualifying disposition. The bargain element at exercise becomes ordinary income (though not subject to Social Security or Medicare), and anything above that is capital gain.

That’s the trade-off. While you wait out the holding period, the stock can fall, but your AMT is based on what the stock was worth on the day you exercised. If the stock plummets, you still owe AMT on the full bargain element, even if the shares are no longer worth enough to sell and cover the bill. In the worst case, the shares go to zero and you’re paying a five-figure AMT bill out of pocket on top of losing the investment itself. A capital loss only offsets $3,000 a year of ordinary income, and the AMT credit comes back slowly.

There is one escape valve. If you sell the shares in the same calendar year you exercised them, it becomes a disqualifying disposition, the AMT adjustment goes away, and if the price has dropped, your ordinary income is limited to your actual gain. So watching the stock price between your exercise date and December 31 matters.

These are serious risks that have wiped out tech workers’ net worth in a heartbeat. The dot-com crash in 2000 and the tech selloff in 2022 both left people with AMT bills on stock that had lost most of its value. It’s also one of the reasons companies move away from ISOs as they mature: most employees don’t fully understand the tax implications of their compensation. With the right planning, like modeling your AMT before you exercise and deciding how many shares to exercise and when, ISOs can still be one of the most valuable forms of equity compensation there is.

This article is for general educational purposes and is not tax advice for your specific situation. Figures reflect 2026 federal tax rules.