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The Executive's Guide to Incentive Stock Option (ISO) Taxation

Incentive stock options can be a powerful tool for wealth accumulation.

But if you don't understand the tax consequences, you can turn an asset into a liability.

This is your guide to avoiding an ISO tax nightmare.

How are Incentive Stock Options Taxed?

You can't begin to understand how ISOs are taxed if you don't understand basic stock option terminology. If you need a primer before we dive into the details, read The Executive's Guide to Equity Compensation.

What happens when you exercise ISOs?

The bargain element is NOT considered income for the ordinary tax calculation, and no federal, state, social security, Medicare, or other taxes are withheld.

However, the bargain element might be included as income in the Alternative Minimum Tax (AMT) calculation.

IRS Form 6251 for Alternative Minimum Tax
IRS Form 6251 for Alternative Minimum Tax

Most people aren't subject to AMT, but ISO exercises are a common trigger.

For a more in-depth explanation of AMT, read Equity Compensation and the Alternative Minimum Tax.

I know it's early, but this is where things start to get tricky. The final tax treatment of exercised ISOs isn't determined until you sell the shares. Let me explain...

ISO Qualifying and Disqualifying Dispositions

ISO sales can either result in a Qualifying Disposition (QD) or a Disqualifying Disposition (DQD). A qualifying disposition occurs when you sell shares:

  • >1 year from the exercise date; AND

  • >2 years from the grant date

Any other sale is a disqualifying disposition with various tax consequences that depend on the holding period from exercise, the stock's value value at exercise and sale, and other specifics related to the ISO grant. We'll use an example to illustrate common scenarios.

Illustration of ISO Exercise & Sale Scenarios

On 7/1/2024, you exercise 1,000 ISO shares at a $10 strike price (SP). The fair market value (FMV) at exercise is $60. The lot was granted on 7/1/2023.

At exercise, you pay $10,000 for the shares ($10 SP x 1,000 shares). Your bargain element is $50,000 ($60 FMV - $10 SP)*1,000 shares.

Using this information, we'll cover what happens in the following scenarios:

  • Exercise and sell immediately (DQD)

  • Exercise and sell in the same tax year (DQD)

  • Exercise and sell in a different tax year (DQD)

  • Exercise and hold to meet the criteria for a QD

Exercise and Sell Immediately

The $50,000 bargain element is considered compensation income and will be included in your regular tax calculation. Since you sold in the year of exercise, there are no AMT considerations.

You have no capital gain because you sold the shares for $60,000, and your basis in the shares is also $60,000 ($10,000 cost of shares + $50,000 bargain element).


Since taxes aren't withheld on ISO exercises, you need to set aside cash to pay federal, state, local, and FICA tax liabilities at filing.

Exercise and Sell in the Same Tax Year

This can play out a few different ways, depending on the stock's performance between the exercise and sale dates.

We'll need to cover tax treatment for the following events:

  • Sale Price > Strike Price AND >FMV at exercise

  • Sale Price > Strike Price BUT <FMV at exercise

  • Sale Price < Strike Price AND <FMV at exercise

Sold in the same tax year for more than the strike price and FMV at exercise

If you sold for $70,000 (Sale Price > Strike Price AND > FMV at exercise), the $50,000 bargain element is compensation income. Your basis is $60,000 ($50,000 bargain element + $10,000 cost), and the $10,000 gain is short-term.

Sold in the same tax year for more than the strike price but less than the FMV at exercise

If you sold for $40,000 (Sale Price > Strike Price BUT < FMV at exercise), the gain of $30,000 ($40,000 sale - $10,000 cost) is compensation income. You'll still report the sale of the shares, but there's no capital gain.

Sold in the same tax year for less than the strike price and FMV at exercise

If you sold for $5,000 (Sale Price < Strike Price AND < FMV at exercise), you have a capital loss of $5,000 ($5,000 sale - $10,000 cost of shares).

Now, what if you hold the shares into the next tax year, but sell before meeting the qualifying disposition criteria?

Exercise and Sell in the Next Tax Year

In 2024, the $50,000 bargain element will not be reported for ordinary taxes, but it will be added to your AMT income.

If this causes you to pay AMT, you'll receive an AMT credit to apply to a future year when you aren't subject to AMT (more on this later).

When you sell in 2025, the compensation income reported is the lesser of:

  • The original bargain element

  • (FMV at Sale - Strike Price)*# of shares

Because you're taxed on the bargain element for regular taxes in 2025, you'll also report that income as a negative adjustment to your 2025 AMT income, to ensure you aren't taxed twice.

In addition, the stock will have a dual basis, one to calculate the regular capital gain/loss and one to calculate the AMT gain/loss.

The difference between the ordinary and AMT gain/loss is also reported as an adjustment for AMT. However, AMT capital losses are capped at the amount of gain reported for regular tax plus $3,000. Any excess losses are carried forward.

If you held the stock for less than a year from the exercise date the gain/loss is short-term. If you held the stock for more than a year from the exercise date but less than 2 years from the grant date, it's a disqualifying disposition, but the gain is long-term.

As you can see, this is one of the more complex scenarios. Finally, let's cover what happens in a qualifying disposition.

Exercise and Hold for a Qualifying Disposition

In 2024, the $50,000 bargain element will be added to your AMT income. Again, you'll receive an AMT credit if the ISO bargain element causes you to pay AMT.

Since you held the shares into a different tax year and sold in a qualifying disposition, the bargain element was never reported for regular taxes, so your dual basis is as follows:

  • AMT basis is $60,000 ($10,000 cost of shares + $50,000 bargain element)

  • Regular tax basis is only the $10,000 cost of the shares.

So, if you sell for $90,000, you have an AMT gain of $30,000 and regular tax gain of $80,000. All else being equal, this likely means your regular tax will be greater than your AMT in the year of the sale. This is where the AMT credit comes in.

The AMT Credit

The AMT credit prevents you from paying tax on the same income for AMT in one year and regular tax in another.

Let's say you have a $10,000 AMT credit from 2024. In 2025, your regular tax is $50,000 and AMT is $36,000. You can use the full $10,000 credit to reduce your regular tax to $40,000 in 2025.

If the regular tax is $50,000 and the AMT is $45,000, you can only use $5,000 of the credit and carry the remaining $5,000 forward to the next tax year. Make sure that you and/or your accountant is tracking the credit to ensure you don't lose it.


Incentive Stock Options can be a powerful way to accumulate wealth, but most executives don't have the time or desire to navigate their complex tax consequences for an advantageous outcome.

However, hoping for the best with your ISOs is a recipe for disaster. Make the most of them with a well-thought exercise and sale strategy.


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