The principal advantages of an ISO, therefore, lie in the deferral of the taxable event and the treatment of income as a long-term capital gain. Due to the fact that an employee receiving an ISO is not treated as receiving direct compensation, the corporation granting the ISO is not entitled to claim a deduction as the result of the grant or exercise of the ISO except in the limited circumstance described below. As noted above, the Code imposes several qualification requirements on ISO's. If the employee fails to meet either of these holding requirements, any gain that results from the disposition of the stock will be treated as ordinary income to the employee. To the extent that ordinary income arises upon a disqualifying disposition, the corporate employer will receive a corresponding deduction.
Any additional gain is taxed as a capital gain.
Thus, a terminating employee must exercise his option within three months after leaving the corporation. The option exercise price must not be less than the fair market value of the underlying stock as of the time the option is granted. The option, by its terms, must be nontransferable other than at death and must be exercisable during the employee's lifetime only by him. The option must be granted within ten years from the date the ISO is adopted or the date the plan is approved by the stockholders, whichever is earlier. The option must, by its terms, not be exercisable after ten years from the date of grant.