Incentive stock options (ISOs) is a term to refer to employee stock option. This stock option can be granted only to employees and allows a U.S. tax benefit.
Economists also sometimes refer ISO stock options as incentive share options or Qualified Stock Options by the IRS. The tax benefit is granted to the individual who does not have to pay ordinary income tax (nor employment taxes) on the difference between the exercise price and the fair market value of the shares issued.
However, the tax benefit holder might be required to pay U.S. alternative minimum tax instead. On the other hand, if the shares are held for 1 year from the date of exercise and 2 years from the date of grant, then the profit 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 ISO stock options have more easy to negotiate tax treatment than non-ISOs or non-qualified stock option (NQO), ISOs also endorse the holders to pay more risk by holding onto the stock for a longer period of time if the holder is going to receive optimal tax treatment. However, even if the holder disposes of the stock within a year, it is possible that there will still be marginal tax deferral value if the holding period, though less than a year, straddles the ending of the taxpayer’s taxable reporting period. An employer generally does not claim a corporate income tax deduction upon the exercise of its employee’s ISOs stock options unless the employee does not meet the holding-period requirements.