ISOs vs NSOs: How Startup Stock Options Are Taxed and Which to Grant

The difference between ISOs and NSOs is when you pay tax and at what rate. With an ISO, nothing is taxed at grant, there is no regular income tax at exercise, and if you meet the holding periods the entire gain over your strike price is long-term capital gain when you sell. With an NSO, nothing is taxed at grant, but at exercise the spread (fair market value minus strike price) is ordinary income, and only post-exercise appreciation can be capital gain.

ISOs look better for the employee on paper. They come with conditions, though: the alternative minimum tax, strict holding periods, a $100,000 annual cap, and a short post-termination exercise window. NSOs are simpler, more flexible, and give the company a tax deduction.

ISOs are governed by IRC §422. At grant, there is no tax, and the strike price must be at least the fair market value of the stock on the grant date. At exercise, there is no regular income tax and no FICA. The company reports the exercise to you on Form 3921 by January 31 of the following year.

The spread at exercise is still counted for the alternative minimum tax. If you exercise 20,000 ISOs at a $1.00 strike when the 409A value is $6.00, you have a $100,000 AMT adjustment that year, whether or not you sell. That is the trap behind most painful ISO stories, and we cover the math in our AMT and ISO exercise guide.

At sale, if you held the shares more than two years from grant and more than one year from exercise, it is a qualifying disposition. Your entire gain above the strike price is long-term capital gain, taxed at 0%, 15% or 20% plus the 3.8% net investment income tax where it applies. Your AMT basis is higher than your regular basis (it includes the spread taxed for AMT), which is how prior AMT is later recovered through the minimum tax credit.

A disqualifying disposition is any sale, gift or other transfer of ISO shares before both holding periods are met. A cash acquisition that closes within a year of your exercise counts.

In a disqualifying disposition, part of your gain becomes ordinary income: the spread at exercise, or your actual gain on the sale if that is smaller (IRC §422(c)(2)). Anything above the exercise-date value is capital gain, short- or long-term depending on how long you held the shares. Using the example above, if you sell those 20,000 shares at $9.00 eight months after exercising, $100,000 is ordinary income and $60,000 is short-term capital gain.

Two quirks are worth knowing. First, the ordinary income from a disqualifying disposition is not subject to FICA or mandatory income tax withholding, so employees often owe more in April than they expect. Second, if the disqualifying disposition happens in the same calendar year as the exercise, the AMT adjustment for those shares disappears. Some employees use that deliberately when the stock price falls after an exercise.

NSOs fall under IRC §83. At exercise, the spread is ordinary income. For employees it is wages: it goes on Form W-2, and the company must withhold federal income tax (the 22% supplemental rate is common; 37% is mandatory on supplemental wages above $1 million in a year), Social Security up to the $184,500 wage base for 2026, and Medicare. For contractors and advisors, the spread is nonemployee compensation reported on Form 1099-NEC, with no withholding.

Your basis in the shares is the strike price plus the income you recognized, which equals the fair market value at exercise. Your capital gains holding period starts at exercise. Later appreciation is capital gain.

On a private company, the practical problem with NSOs is cash. Exercising a large grant after the company's value has grown creates real taxable income with no market to sell shares into. That is one reason early-exercise programs exist.

Under §422(d), ISOs that first become exercisable by one employee in a calendar year are capped at $100,000, measured using the stock's fair market value on the grant date multiplied by the number of shares. Anything above the cap is automatically treated as an NSO. It is not a cap on how much you can be granted, only on how much can be ISO in a given vesting year.

Example: an employee receives 200,000 options at a $2.00 strike ($400,000 of grant-date value) vesting evenly over four years. Each year $100,000 becomes exercisable, so the whole grant fits. If the same grant had a one-year cliff with 25% vesting, then monthly, it still fits. But if the plan allows early exercise, all $400,000 is exercisable in the grant year, so only $100,000 is ISO and $300,000 is NSO (Treas. Reg. 1.422-4 orders the options by grant date).

Most cap table software can track the split, but check that your grant records actually show the ISO and NSO portions.

To keep ISO treatment, you must exercise within three months after your employment ends (§422(a)(2)), extended to one year if you leave because of permanent and total disability. An option exercised after that point is taxed as an NSO, even if the agreement still lets you exercise.

Many startups now extend the post-termination exercise period to several years, which is generous to departing employees. The cost is that the extended option is an NSO once the three-month window passes. Employees deciding whether to exercise on departure should treat the 90-day deadline as an ISO deadline and the contractual deadline as an NSO deadline.

Other ISO requirements are technical but they matter: the plan must be approved by stockholders within 12 months of adoption, options must be granted within 10 years of plan adoption and expire within 10 years of grant, and an employee who owns more than 10% of the voting power can only receive ISOs priced at 110% of fair market value with a maximum five-year term.

ISOs can only be granted to employees of the company or its parent or subsidiary corporations. That rule decides most cases for you:

• Employees on US payroll: ISOs by default, up to the $100,000 limit.
• Advisors, consultants and contractors: NSOs, because they are not employees.
• Non-employee board members: NSOs.
• Employees of a foreign subsidiary: ISOs are technically possible for subsidiary employees, but local tax rules usually drive the choice, and NSOs (or local plan sub-schemes) are common.
• Founders with more than 10% of voting power: ISOs only on the 110% and five-year terms, so most founders get restricted stock instead.

We usually tell seed and Series A companies to grant ISOs to employees, because employees value them and the company's lost deduction is worth little when the company has net operating losses. Later-stage, profitable companies sometimes prefer NSOs because the deduction under §83(h) has real value.

Take a hypothetical employee with 20,000 options at a $1.00 strike who exercises in 2026 when the 409A value is $6.00, then sells in 2028 at $15.00, more than two years after grant and one year after exercise.

As an ISO: no regular tax at exercise. The $100,000 spread is an AMT adjustment in 2026, which may or may not produce AMT depending on other income. At sale, the full $280,000 gain ($15.00 minus $1.00, times 20,000) is long-term capital gain. The company gets no deduction.

As an NSO: the $100,000 spread is wages in 2026, with income tax and FICA withheld at exercise. At sale, the $180,000 gain above the $6.00 exercise-date value is long-term capital gain. The company deducts $100,000 in 2026.

At a 35% marginal ordinary rate versus a 20% capital gains rate, the ISO version saves the employee roughly $15,000 of federal income tax on the $100,000 spread, plus the employee share of Medicare and possibly Social Security, assuming no AMT. If the employee had instead sold within a year of exercise, the ISO would have been a disqualifying disposition and the result would look much like the NSO, minus the payroll tax. The arithmetic is illustrative, but it shows why holding periods drive the value of ISO status.

For NSOs, the company deducts the amount the employee or contractor includes in income, in the same tax year (§83(h)). It must also withhold and pay the employer share of FICA on employee exercises, which can be a real cash outflow on a big exercise.

For ISOs, the company gets no deduction (§421(a)) unless the employee makes a disqualifying disposition, in which case the company can deduct the ordinary income the employee recognizes. In practice, companies rarely learn about disqualifying dispositions unless they track sales, so many never claim it. The company must file Form 3921 with the IRS and furnish a copy to each employee who exercised ISOs during the year.

If you are setting up a plan or a grant policy, get the 409A in place first so every strike price is defensible. Not tax advice for your specific facts; plan design varies by company, so review your plan document with counsel.