How ISOs Are Taxed: Exercise, AMT and Sale

Figures for tax year

The three moments

Grant and vest: no tax

Nothing happens at grant or vest.

Exercise: no regular tax, but AMT may apply

When you exercise ISOs, you pay the strike price and receive shares. For regular income tax, nothing is owed. But the spread (market value minus strike) is added to your income for the alternative minimum tax. Big exercises can trigger AMT. See ISOs and the AMT.

Sale: depends on how long you held

Qualifying disposition. You sell at least 2 years after grant and 1 year after exercise. The entire gain over your strike price is long-term capital gain.

Disqualifying disposition. You sell earlier. The spread at exercise (or your actual gain, if lower) becomes ordinary income. Any extra growth is a capital gain, short- or long-term depending on how long you held after exercise.

An example

You exercise 7,500 ISOs with a $2 strike when the stock is worth $12.

Cash to exercise: $15,000
AMT spread: $75,000

You later sell at $40.

Qualifying sale: $285,000 long-term gain, at 20% plus 3.8% for high earners
Disqualifying sale: $75,000 ordinary income plus $210,000 capital gain

Things employers don't withhold

A disqualifying disposition creates ordinary income on your W-2, but no income tax is withheld and no Social Security or Medicare applies. Plan to pay it through estimated taxes.

The $100,000 limit

Only $100,000 of ISOs, measured at the grant-date value, can first become exercisable in any calendar year. Anything above that is treated as NSOs automatically. Your grant documents or equity portal usually show the split.

If you leave the company

ISOs must be exercised within 3 months of leaving to keep ISO status. Many plans give you 90 days before the options expire. See Leaving a startup.

Common strategies

Exercise early, when the spread is small, to limit AMT and start the holding clock. See Early exercise and 83(b).
Exercise in stages each year, up to your AMT crossover point.
Exercise and sell at IPO, a disqualifying sale that avoids AMT entirely.

Compare strategies with the Exercise Timing calculator.

General information, not tax advice.

Frequently asked questions

Do I pay taxes when my ISOs are granted or vested?

No, there are no tax consequences at the time of grant or vesting. You do not owe regular income tax when you exercise your options, although the spread between the market value and your strike price may trigger the alternative minimum tax. Taxes only become due once you eventually sell your shares.

What is the difference between a qualifying and disqualifying disposition for ISOs?

A qualifying disposition occurs when you sell your shares at least two years after the grant date and one year after exercise, allowing the entire gain to be taxed as long-term capital gain. A disqualifying disposition happens if you sell sooner, causing the initial spread at exercise to be taxed as ordinary income instead.

Does my employer withhold taxes on ISO disqualifying dispositions?

Even though a disqualifying disposition results in ordinary income reported on your W-2, your employer will not withhold any income tax. Furthermore, Social Security and Medicare taxes do not apply to this income. You are responsible for planning to pay these taxes yourself through estimated tax payments.

What happens to my ISOs if I quit my job?

If you leave your startup, you must exercise your ISOs within three months of your departure to maintain their ISO tax status. Many company plans also require you to exercise within 90 days before the options expire entirely. Check your specific grant documents or equity portal for your deadline.