NSOs vs. ISOs: How the Two Kinds of Stock Options Are Taxed Differently

The grant letter may look the same, but the letters "ISO" or "NSO" change when you owe tax, how much, and which forms show up in April.

Stock options at Bay Area companies come in two legal flavors: incentive stock options (ISOs) and nonstatutory or nonqualified stock options (NSOs). Both give you the right to buy shares at a fixed strike price for a set period. The difference lies almost entirely in the tax code. Understanding it can change how you think about the timing of an exercise, the cash you need to set aside, and whether the alternative minimum tax (AMT) becomes part of your life.

NSOs: ordinary income at exercise

An NSO is the simpler case. When you exercise, the spread between the fair market value of the shares and the strike price is treated as compensation, as described in IRS Topic 427. It shows up on your W-2, and your employer withholds on it. Federal supplemental withholding is generally 22% on the first $1 million of supplemental wages in a year and 37% above that, per IRS Publication 15. California applies its own supplemental rate, and the California equity compensation withholding rate of 10.23% is frequently lower than a high earner's actual marginal rate. Employees who exercise a large NSO block often discover in April that withholding did not keep pace with the bill.

After exercise, your basis in the shares equals the strike price plus the income you recognized. Any later gain or loss is capital, and it becomes long-term if you hold the shares more than one year from exercise. NSOs can be granted to anyone, including contractors and advisers.

ISOs: no regular tax at exercise, but AMT

An ISO can be granted only to employees, and the statute governing ISOs limits the value of ISOs that first become exercisable in any calendar year to $100,000, measured at the grant-date price; options above that line are treated as NSOs. If you exercise and hold, there is no regular income tax at exercise. Instead, the spread is a preference item for AMT, calculated on Form 6251. For 2026, the AMT exemption is $90,100 for single filers and $140,200 for married couples filing jointly, and it begins to phase out at $500,000 and $1,000,000 of AMT income, according to the IRS inflation adjustments. A large exercise can push a household well past that exemption and create a substantial AMT bill on paper gains that have not been sold.

The reward for accepting that complexity is the qualifying disposition. If you hold ISO shares at least two years from grant and one year from exercise, the entire gain from the strike price to the sale price is long-term capital gain. Sell earlier and the transaction becomes a disqualifying disposition: the spread at exercise (or the actual gain, if lower) is taxed as ordinary income, much like an NSO. California follows the federal ISO rules for regular tax purposes but, as the NerdWallet California tax summary notes, the state taxes capital gains as ordinary income at rates up to 13.3%, so the federal long-term rate advantage does not carry over at the state level.

Withholding and reporting differences

Because an ISO exercise is not a wage event, your employer does not withhold on it, and there is no Social Security or Medicare tax on the spread. That sounds attractive until you remember that any AMT or tax on a disqualifying disposition must be paid through estimated payments or a lump sum at filing. Employers report ISO exercises on Form 3921, which the IRS Topic 427 page explains, and you or your preparer must track the AMT basis separately from the regular basis. Double-counting income when shares are eventually sold is a common error.

Which is better?

Neither type is better in the abstract. ISOs offer a potentially lower total tax rate, but only if you can afford to exercise with cash, carry the AMT exposure, and hold through a period in which the stock may fall. NSOs are simpler and generate tax at a known moment, but at ordinary rates. Many Silicon Valley employees hold both, often because the $100,000 limit converted part of a large grant to NSOs automatically, and an exercise plan may treat the two pools differently.

Considerations that tend to matter include your marginal rate this year versus expected future years, the spread relative to the strike price, whether the company is public or private, and how much of your net worth is already tied to your employer. This article is educational and is not investment, tax, or legal advice; please consult a qualified tax professional about your own situation.

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