By Kevin Luu, Co-Founder and Chief Learning Officer. Reviewed on 2026-09-30.
ISOs, or incentive stock options, are employee stock options that get special federal tax treatment under Section 422 of the tax code. An ISO gives you the right to buy your employer’s stock at a fixed price (the strike price) for up to ten years. You owe no regular income tax when the option is granted or when you exercise it, and if you hold the shares long enough, the entire gain can be taxed at long-term capital gains rates instead of wage rates.
The catch is that the paper profit at exercise counts for the alternative minimum tax (AMT), and the special treatment disappears if you sell too soon. For a household earning $1M or more in California or Washington, those two details decide whether an ISO grant behaves like a tax-advantaged asset or like an ordinary bonus.
What makes an option an ISO and not an NSO
Companies can grant two kinds of options: ISOs and nonqualified stock options (NSOs). An option only counts as an ISO if the plan and the grant meet the conditions in IRC §422. The ones that matter in practice:
- Employees only. ISOs can go only to employees, not to advisers, board members or contractors. You generally must exercise within three months of leaving the company, or the option is taxed as an NSO.
- Strike price at least fair market value on the grant date. There is no built-in discount, which is different from an ESPP.
- Ten-year maximum term. The option must expire no later than ten years after grant.
- The $100,000 rule. If more than $100,000 of stock (valued at grant-date fair market value) becomes first exercisable in one calendar year, the excess is treated as NSOs (IRC §422(d)). This is why large grants at well-funded startups often arrive as a mix of ISOs and NSOs.
Your grant agreement or equity portal labels each tranche as ISO or NSO. Check it. Many people at late-stage private companies in the Bay Area and Seattle assume everything is an ISO when part of the grant is not.
How an ISO is taxed at each step
| Event | Regular federal tax | AMT | California |
|---|---|---|---|
| Grant | None | None | None |
| Vest | None | None | None |
| Exercise and hold | None (IRS Topic 427) | The spread (market value minus strike) is added to AMT income | The spread can also count toward California’s own AMT (Schedule P) |
| Sale after 2 years from grant and 1 year from exercise | Whole gain over strike is long-term capital gain | Prior AMT can often be recovered through the minimum tax credit | Whole gain taxed as ordinary income |
| Sale before those dates (disqualifying disposition) | Spread at exercise is ordinary income; any extra gain is capital gain | No AMT adjustment if sold in the same year as exercise | Ordinary income |
The holding periods come from IRC §422(a)(1): no sale within two years of the grant date or within one year of the exercise date. Your employer reports each ISO exercise to you on Form 3921, and the details are covered in IRS Publication 525.
Worked example: a $1.2M household in California with ISOs
Assumptions (illustrative): a married couple in San Mateo County with $1.2M of combined W-2 income, filing jointly, two children ages 4 and 7. One spouse holds 8,000 vested ISOs at a $20 strike in a company that now trades at $70. They exercise all 8,000 and later sell at $90.
- Cash to exercise: 8,000 x $20 = $160,000.
- Spread at exercise: 8,000 x ($70 minus $20) = $400,000. No regular income tax, but the full $400,000 goes into the AMT calculation for the exercise year.
- Total gain at sale: 8,000 x ($90 minus $20) = $560,000.
Path A: qualifying sale (held more than one year after exercise and two years after grant). The $560,000 is long-term capital gain. At this income, the federal rate is 20% (the 2026 20% rate starts above $613,700 of taxable income for joint filers) plus the 3.8% net investment income tax. Federal tax: $560,000 x 23.8% = $133,280.
Path B: disqualifying sale (sold within a year of exercise). The $400,000 spread becomes ordinary income at the 37% bracket (which starts at $768,700 of taxable income for 2026), or $148,000. The extra $160,000 is a short-term gain taxed at 37% plus 3.8%, or $65,280. Federal tax: $213,280.
The federal difference is $80,000. But Path A has two costs the table hides. First, the AMT on a $400,000 spread for a household at this income can be large, and it is due with the return for the exercise year even though no shares were sold. Second, the family carries a concentrated $560,000 position for a year or more. If the stock falls back to $30 after the exercise year ends, most of the gain is gone, yet the AMT was figured on the full $400,000 spread. Part of it may come back over later years as a minimum tax credit, but not right away.
California taxes the gain the same way under either path. California has no lower rate for capital gains (FTB), so the $560,000 is taxed as ordinary income either way, at marginal rates up to 13.3% (2025 schedule, including the 1% tax on taxable income over $1M). California also has its own AMT, at 7% for 2025 (Schedule P (540)), so a large exercise can trigger a California AMT bill as well.
How the same ISO plays out in Washington
A Washington family in the same position pays no state tax on the exercise and no state tax on a disqualifying sale, because Washington has no wage income tax in 2026 (WA DOR). A qualifying sale is different. The long-term gain can fall under Washington’s capital gains tax: 7% on taxable gains above the standard deduction ($278,000 for 2025, the latest published figure) and 9.9% on taxable gains above $1M (WA DOR). In the example, roughly $282,000 of the $560,000 gain would be above that deduction, assuming no other long-term gains that year. Washington is also adding a 9.9% income tax on AGI over $1M starting January 1, 2028, so a sale planned for 2028 or later needs a fresh look once DOR publishes guidance.
The decision a family with ISOs actually has to make
Knowing what ISOs are is the easy part. The real choices are:
- When to exercise. Exercising early, while the spread is small, keeps the AMT exposure low but puts cash at risk in a company that may never go public. Exercising late (or at a liquidity event) costs less risk but often more tax.
- How much to exercise each year. Many families exercise in slices sized so the spread stays below the point where AMT kicks in, using a projection of that year’s return.
- Whether to hold for the qualifying date. The tax saving has to be weighed against how much of the family’s net worth sits in one stock.
- What happens if you leave. An ISO exercised more than three months after you leave is taxed as an NSO, if the plan allows a later exercise at all. Many plans simply let unexercised options expire, so check your plan’s post-termination window.
If your company allows a cashless exercise, the shares are usually sold the same day, which is automatically a disqualifying disposition. We cover that trade-off in tax on cashless exercise of stock options. If your company is private and offers to buy shares back, see how a tender offer works. And if you also hold RSUs, the comparison in do RSUs have a strike price explains why RSUs carry none of these timing decisions.
Common mistakes with ISOs
- Treating “no tax at exercise” as no tax. The AMT can apply in the exercise year, and in California a second AMT can apply on top.
- Missing the qualifying date by days. Both clocks must be satisfied: two years from grant and one year from exercise.
- Exercising late in the year without a projection. An exercise in December leaves no time to sell in the same year if the price drops, which is the usual way to undo an AMT problem.
- Forgetting withholding does not exist here. Unlike RSUs, an ISO exercise creates no wages to withhold on, and employers are not required to withhold federal income tax on a disqualifying disposition (IRC §421(b)), so the bill often shows up at filing unless estimated payments are made.
What to write down for your kids
An ISO decision is a clean example of judgment under uncertainty: how much risk you took, why you held or sold, and what you would do differently. A one-page note covering the grant, the exercise, the tax cost and the outcome is the kind of record children can learn from years later. As Kevin Luu puts it: “Your kids don’t need to inherit your portfolio. They need to inherit your decision-making process.”
That is the thinking behind the FamilyKnowledge® System and our family governance work.
Next step
Pull your grant documents and Form 3921s, list each tranche as ISO or NSO with its strike price, grant date and expiration, and run a tax projection before any exercise. If you want a second set of eyes on the AMT and state tax picture, our tax management team does this as part of the Tax & Wealth Assessment.
This is general education, and the right move depends on the family’s full picture.
Kevin has advised high-income W-2 tech and biotech families since 2015, and leads the education-first Age Five Family Office from Brea, California.
Connect on LinkedIn → · About KevinThis is part of how we approach Tax Management for high-income W-2 families at Bright Advisers.
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