What is the tax implication when using ISO stock options?

When it comes to Incentive Stock Options (ISOs), the critical aspect to understand is that there are no immediate tax implications at the time of grant or at the time of exercising the options, as long as certain conditions are met. Instead, the tax consequence is deferred until the stock acquired through the exercise of ISOs is sold.

Upon exercising ISOs, an employee does not recognize ordinary income; instead, the potential tax obligation is triggered when they sell the stock. If the stock is held for a minimum period — specifically, more than one year after exercise and two years after the grant — the gains from the sale of the stock can be taxed at the long-term capital gains rate, which is generally more favorable than ordinary income tax rates.

This deferral of tax until the stock is sold is a significant benefit of ISOs, as it allows employees to potentially convert their gains to more favorable tax treatment if they meet the holding period requirements.