Also known as an ISO. A type of stock option that can be granted only to employees and can qualify as a "statutory stock option" under the Internal Revenue Code (IRC) to receive tax-favorable treatment. If qualified, ISOs are not subject to ordinary income taxes at grant or exercise. Instead, only the profit made on any sale of the underlying shares is taxed, at prevailing long-term capital gains rates. Under certain circumstances, the holder of an ISO may also be subject to alternative minimum tax in the year the ISO is exercised.

To qualify, an ISO must satisfy the requirements of Code Section 422, including a requirement that the ISO be issued pursuant to a qualifying, stockholder-approved plan. In addition, to be entitled to tax-favorable treatment, the holder of an ISO must hold the underlying shares until the later of one year from the date of exercise or two years from the date of grant of the option.

For more information about incentive stock options and other types of stock options and equity compensation, see Practice Notes, Stock Options: Overview and Equity Compensation Awards: Overview. For a model incentive stock option agreement, see Standard Document, Incentive Stock Option Agreement.