What is an Incentive Stock Option (ISO)?

An Incentive Stock Option, or ISO, is a form of equity compensation that corporations can grant specifically to employees.

It gives the employee the right to buy shares of the company stock at a specific price at a later date.

The primary distinction of an ISO compared to other forms of equity is the potential for favorable tax treatment. Because these options meet specific stipulations in the Internal Revenue Code, they allow employees to potentially avoid paying taxes at the time they exercise the option.

For a founder, understanding ISOs is critical because equity is often the most valuable currency a startup has to attract top talent.

When you grant an ISO, you set a strike price. This is usually the fair market value of the stock at the time of the grant.

The employee must wait for the options to vest before they can exercise them. Vesting schedules typically span four years with a one year cliff.

Once vested, the employee can choose to exercise the option. This means they pay the strike price to purchase the stock. If the company has grown, the current value of the stock should be higher than the strike price.

The main draw of an ISO is the tax benefit.

With other types of options, the difference between the strike price and the current value is taxed as ordinary income the moment the option is exercised.

With an ISO, no ordinary income tax is due at exercise. Taxes are generally deferred until the employee sells the stock.

If the employee holds the stock for at least one year after exercising and two years after the grant date, the profit is taxed at the lower long term capital gains rate.

However, there is a catch.

The spread at exercise is considered for the Alternative Minimum Tax (AMT). This can result in a surprise tax bill for employees if they are not careful.

It is common to compare Incentive Stock Options with Non-Qualified Stock Options (NSOs).

Here are the primary differences:

• Eligibility: ISOs can only be granted to employees. NSOs can be granted to employees, contractors, advisors, and directors.
• Tax at Exercise: ISOs do not trigger ordinary income tax at exercise. NSOs trigger income tax on the spread immediately.
• Limits: ISOs have a 100,000 dollar limit on the value of options that can become exercisable in a calendar year. NSOs have no such limit.

Founders often use ISOs for core team members to maximize their long term upside.

Choosing to issue ISOs requires strict adherence to regulations.

If the specific holding periods are not met, the sale of the stock becomes a disqualifying disposition. This reverts the tax treatment back to ordinary income rates.

Furthermore, ISOs usually must be exercised within 90 days of an employee leaving the company. This can create golden handcuffs where employees cannot afford to leave because they cannot afford to buy their stock.

Founders must weigh the administrative complexity against the recruitment benefits.

Is the tax advantage worth the strict regulatory framework?

Does your team understand the nuances of AMT?

These are the questions you must answer before setting up your option pool.