ISOs and NSOs: How Each Stock Option Is Taxed
The two kinds of employee stock options, what happens at exercise and at sale under each, the alternative minimum tax trap, and the holding periods that decide the rate.
Reviewed by the Fairlight Accounting cross-border tax team — U.S. & Canadian Tax Desks
A nonqualified stock option (NSO) is taxed at exercise: the spread is ordinary wage income, and later appreciation is capital gain. An incentive stock option (ISO) has no regular tax at exercise, but the spread counts for the alternative minimum tax, and the full gain is capital gain only if holding periods are met.
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How do they compare?
| Event | NSO | ISO |
|---|---|---|
| Grant | No tax | No tax |
| Exercise | Spread is ordinary income (W-2 wages for employees; subject to payroll tax) | No regular tax; spread is an AMT adjustment |
| Sale after the holding periods | Gain above the exercise-date value is capital gain | Entire gain above the exercise price is long-term capital gain |
| Sale before the holding periods | Capital gain or loss from the exercise-date value | Disqualifying disposition: spread (limited to actual gain) is ordinary income; the rest is capital gain |
| Employer deduction | Equal to the employee's ordinary income | None, unless there is a disqualifying disposition |
| Who can receive | Employees, contractors, directors | Employees only |
| Annual limit | None | $100,000 of stock (valued at grant) first becoming exercisable in any calendar year; the excess is treated as NSOs |
| Term | Set by the plan | 10 years (5 for more-than-10 percent owners, who also need a 110 percent exercise price) |
What is the AMT trap?
Exercising ISOs and holding the shares creates alternative minimum taxable income equal to the spread, with no cash from a sale to pay it. A large exercise in a rising market can produce a tax bill on paper gains that then evaporate. The AMT paid generates a credit usable in later years, but only against regular tax above AMT. Exercising in stages, or selling enough shares in a disqualifying disposition to cover the tax, are the usual responses.
How does a disqualifying disposition work?
Selling ISO shares before the holding periods — two years from grant and one year from exercise — converts the spread at exercise into ordinary income in the year of sale — but limited to the actual gain if the shares fell. There is no payroll tax on that income, and the employer gets a matching deduction. A sale in the same year as exercise also removes the AMT adjustment for that year.
What is early exercise?
Some plans allow exercising unvested options, receiving restricted stock. With an 83(b) election filed within 30 days, the spread (often zero) is taxed at exercise — for ISOs, only for AMT purposes — and the holding periods start immediately — the structure founders and early employees use to convert future appreciation into long-term capital gain.
Frequently asked questions
Which is better for the employee?
ISOs, if the AMT can be managed and the holding periods met; NSOs are simpler and the employer gets a deduction.
Are options granted below market value allowed?
NSOs granted below fair market value are deferred compensation under Section 409A and generally fail it unless exercise is limited to a fixed date or permitted payment event; an ISO's exercise price must by statute be at least fair market value at grant (110 percent for more-than-10 percent owners).
What is reported on my W-2?
The NSO spread at exercise, and the ordinary income from an ISO disqualifying disposition. ISO exercises are reported separately on Form 3921 (and employee stock purchase plan transfers on Form 3922).
Do state taxes follow federal treatment?
Mostly, with differences in AMT and in sourcing for employees who move between states.
Official sources
The IRS explains: “If your employer grants you a statutory stock option, you generally don't include any amount in your gross income when you receive or exercise the option. However, you may be subject to alternative minimum tax in the year you exercise an ISO.” — Internal Revenue Service, Topic no. 427, Stock options, https://www.irs.gov/taxtopics/tc427
The IRS explains: “If you sell stock acquired by exercising an ISO, don’t satisfy the holding period requirement, and have a gain from the sale, the gain is ordinary income up to the amount by which the stock’s FMV when you exercised the option exceeded the option price. Any excess gain is capital gain.” — Internal Revenue Service, Publication 525 (2025), Taxable and Nontaxable Income, https://www.irs.gov/publications/p525
Next step
Fairlight Accounting handles U.S. domestic, cross-border (U.S.–Canada), and international tax returns, plus bookkeeping, payroll, and CFO advisory. Our U.S. Tax Desk models exercise timing against the alternative minimum tax before options are exercised. See pricing or book a free fit call.
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