Incentive stock option

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Incentive stock options (ISO's), are a type of employee stock option that can be granted only to employees and confer a U.S. tax benefit.

The tax benefit is not having to pay Income tax in the United States ordinary income tax on exercise on the difference between the exercise price and the fair market value of the shares issued (however, the holder may have to pay U.S. alternative minimum tax instead). Instead, if the shares are held for 1 year from the date of exercise and 2 years from the date of grant, then the profit (if any) made on sale of the shares is taxed as long-term capital gain. Long-term capital gain is taxed in the U.S. at lower rates than ordinary income.

Although ISOs have more favorable tax treatment than non-ISOs (aka NSO or NQSO), they also require the holder to take on more risk by having to hold onto the stock for a longer period of time in order to receive the better tax treatment.

Note further that an employer generally does not claim a corporate income tax deduction upon the exercise of its employee's ISO, unless the employee does not meet the holding-period requirements. But see Coughlan, Section 174 R&E Deduction Upon Statutory Stock Option Exercise, 58 Tax Law. 435 (2005). With NQSOs, on the other hand, the employer is always eligible to claim a deduction upon its employee's exercise of the NQSO.

Additionally, there are several other restrictions which have to be met (by the employer or employee) in order to qualify the compensatory stock option as an ISO.