ISOs and NSOs are both stock options. The difference is tax. ISOs (incentive stock options) can only go to employees. If the employee holds the shares long enough, the whole gain is taxed as long-term capital gain, with no regular income tax at exercise, though the alternative minimum tax (AMT) can apply. NSOs (non-qualified stock options) can go to anyone, including contractors and advisors, but the spread at exercise, meaning what the stock is worth when the option is exercised minus the exercise price, is taxed as ordinary income. Most startups grant ISOs to US employees and NSOs to everyone else.
What is the spread?
It’s the built-in gain on an option at the moment it’s exercised. If your exercise price is $0.50 a share and the stock is worth $3.00 when you exercise, the spread is $2.50 a share. The spread is what gets taxed at exercise, and it’s the number that separates ISOs from NSOs.
Key takeaways
- Only employees can receive ISOs. Contractors, advisors and board members get NSOs.
- NSOs are taxed as ordinary income on the spread at exercise.
- ISOs avoid regular tax at exercise, but the spread can trigger AMT.
- An ISO converts to an NSO if it isn’t exercised within 3 months after employment ends.
ISO vs NSO at a glance
| ISO | NSO | |
| Who can receive it | Employees only | Anyone: employees, contractors, advisors, directors |
| Exercise price | At least fair market value (110% for 10%+ holders) | At least fair market value (to avoid Section 409A problems) |
| Tax at grant | None | None |
| Tax at exercise | No regular income tax; the spread counts toward AMT | Spread taxed as ordinary income (withholding for employees) |
| Tax at sale | All gain is long-term capital gain if holding periods are met | Gain after exercise is capital gain |
| Holding period for best treatment | 2 years from grant and 1 year from exercise | 1 year from exercise for long-term capital gain |
| After employment ends | Must exercise within 3 months to stay an ISO | Whatever the plan allows |
| Company tax deduction | None, unless the employee sells early | Yes, equal to the employee’s ordinary income |
| Company reporting | Form 3921 | W-2 (employees) or 1099 (contractors) |
How are ISOs and NSOs taxed?
Say an employee has an option on 20,000 shares at $0.50 per share, the fair market value on the grant date. A few years later, the stock’s fair market value is $3.00, and the employee exercises. The spread is $2.50 per share, or $50,000. Later, they sell all the shares at $10.00.
If it’s an NSO:
- At exercise: $50,000 of ordinary income, even though nothing has been sold. For an employee, the company withholds income and payroll taxes.
- At sale: $140,000 of capital gain ($10.00 − $3.00 = $7.00 × 20,000 shares). It’s long-term if they’ve held the shares for more than a year after exercise.
If it’s an ISO, and they meet the holding periods:
- At exercise: no regular income tax. But the $50,000 spread counts as income for AMT purposes that year.
- At sale: $190,000 of long-term capital gain ($10.00 − $0.50 = $9.50 × 20,000 shares).
If it’s an ISO, and they sell too early (a “disqualifying disposition”): the spread at exercise is taxed as ordinary income in the year of the sale, which is roughly the NSO result.
What is AMT? The alternative minimum tax is a second way of calculating income tax that runs alongside the regular one, and you pay whichever is higher. The spread on ISOs you exercise and keep counts toward AMT, so exercising ISOs can create a tax bill even though no shares were sold. Whether it does depends on the rest of your tax picture, which is why employees should talk to a tax advisor before exercising ISOs.
This page explains how the rules work in general. It is not tax advice for any individual.
Who can receive ISOs, and what makes an option qualify?
An option is an ISO only if all of these are true:
- The recipient is an employee of the company (or its parent or subsidiary). Contractors, advisors and non-employee directors can’t receive ISOs.
- The company is a corporation. LLCs taxed as partnerships can’t grant ISOs.
- It’s granted under a stock plan that stockholders approved within 12 months of the board adopting it.
- The exercise price is at least the fair market value on the grant date, usually set by a 409A valuation.
- The term is 10 years or less.
- It can’t be transferred except at death.
10% stockholders (usually founders) can still receive ISOs, but the exercise price must be at least 110% of fair market value and the term 5 years or less.
If a grant misses any of these requirements, it’s still a valid option. It’s simply treated as an NSO, even if the board meant it to be an ISO.
What does an employee need to do to get the ISO tax benefit?
Hold the shares more than 2 years from the grant date and more than 1 year from exercise before selling. These aren’t conditions for receiving an ISO. They’re conditions for the best tax result when the shares are sold.
What is the $100,000 rule?
ISO treatment is limited to $100,000 of options that first become exercisable in any calendar year, measured at the grant-date value. Anything above that is automatically an NSO. Example: a grant of 200,000 options at $1.00 that vests evenly over 4 years makes $50,000 exercisable each year, so it’s all ISO. The same grant vesting over 1 year would be half ISO and half NSO. Early-exercisable options are all exercisable at grant, so they can hit the limit right away.
What happens to ISOs when an employee leaves?
To keep ISO treatment, the employee must exercise within 3 months after employment ends (12 months if the departure is due to disability). That includes an employee who stays on as a contractor, because the 3 months run from the end of employment. Many startups now give departing employees longer, sometimes years. That’s generous, but any ISO exercised after the 3-month mark is taxed as an NSO. Extending the window for options someone already holds is also treated as a new grant for tax purposes. If the stock is worth more than the exercise price at that point, the option stops being an ISO right away, not just after 3 months. Talk to counsel before changing any outstanding option. See What Happens to Startup Stock When You Leave the Company.
What changes can cost an ISO its status?
Companies usually lose ISO treatment while trying to help their employees, and four moves cause most of the trouble. The first is an open offer. If the company offers to change an ISO, for example to extend the exercise window, and the offer stays open for 30 days or more, the option becomes an NSO even if the employee never accepts. The second is accelerating vesting. Acceleration isn’t a problem in itself, but it can make more options exercisable in a single year, and anything that pushes the grant over the $100,000 limit becomes an NSO. The third is repricing. Lowering the exercise price of an underwater option, or swapping it for a new one, counts as a new grant, so the holding periods start over and the full value of the repriced option counts toward that year’s $100,000 limit. The fourth is cashless exercise in a tender offer or secondary sale, where the buyer or the company covers the exercise price out of the sale proceeds. The portion of an ISO exercised that way becomes an NSO.
None of these is off limits, but each one can cost employees the ISO tax benefit and leave the company with withholding and reporting obligations it didn’t plan for. Check with counsel before changing any outstanding ISO, and before offering a liquidity program to option holders.
Which should my startup grant?
Our default: ISOs to US employees, up to the $100,000 limit, and NSOs to everyone else. Your stock plan should allow both, so you don’t need an amendment when you sign your first advisor. See Employee Stock Option Plan.
What about international team members?
Contractors and advisors anywhere in the world can only receive NSOs. Non-US employees can technically receive ISOs, but they get no US tax benefit, and their local tax rules decide how the option is taxed. So most startups grant NSOs outside the US and check local rules before the first grant in a new country. Some countries require a local sub-plan or filing. See Independent Contractor vs Employee.
What happens to options in an acquisition?
If the buyer cashes out options that haven’t been exercised, the holder is paid the spread as ordinary income, whether the options were ISOs or NSOs. The ISO tax benefit applies only to shares that were actually exercised and held.
How does an employee exercise an option?
They sign the exercise notice from the stock plan and pay the exercise price, usually by wire or check. NSO exercises by employees also require paying the withholding tax. The company then issues the shares and updates the cap table (in Carta or similar). Cashless or “net” exercise is available only if the plan allows it, and that’s rare before an IPO.
What does the company have to report?
- ISO exercises: file Form 3921 with the IRS for each exercise, and give the employee a copy by January 31 of the following year. The IRS copy is due February 28 if filed on paper or March 31 if filed electronically, and a deadline that falls on a weekend or holiday moves to the next business day.
- NSO exercises by employees: run the spread through payroll and report it on the employee’s W-2.
- NSO exercises by contractors: report the spread on a Form 1099.
If your accountant asks whether there were any exercises last year, pull the exercise log from your cap table platform.
Related: Stock Options: What They Mean for Your Startup · Early-Exercisable Stock Options · 409A Valuations · Vesting Schedules
