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An incentive stock option (ISO) is a corporate benefit that gives an employee the right to buy shares of company stock at a discounted price with the added benefit of possible tax breaks on the profit.
A stock option plan is a mechanism for affording selected employees and executives or managers of a company the opportunity to acquire stock in their company at a price determined at the time the options are granted and fixed for the term of the options.
There are many requirements on using ISOs. First, the employee must not sell the stock until after two years from the date of receiving the options, and they must hold the stock for at least a year after exercising the option like other capital gains. Secondly, the stock option must last ten years.
The main difference between ISOs and NSOs is that ISOs come with no tax liability on exercise, but come with a set of requirements, whereas NSOs come with tax liability on exercise, but do not have the same requirements.
Before options can be written, a stock must be properly registered, have a sufficient number of shares, be held by enough shareholders, have sufficient volume, and be priced high enough.
Vesting: ISOs usually contain a vesting schedule that must be satisfied before the employee can exercise the options. The standard three-year cliff schedule is used in some cases, where the employee becomes fully vested in all of the options issued to them at that time.
ISOs are issued only to employees, whereas NSOs can be granted to outside service providers like advisors, board directors or other consultants. Typically, mainly senior executives or key employees are given ISOs as the company is not required to offer ISOs to all employees.
The cost basis of the ISO shares is the price paid for regular tax purposes: the exercise or strike price. It's the strike price plus the AMT adjustment, the amount reported on Form 6251, line 2i, for AMT purposes.