ISO vs NSO: the differences in tax, eligibility and limits

Capable TeamSeptember 16, 20264 min read

The short answer

ISOs (incentive stock options) can go only to employees and can qualify for long-term capital gains tax on the entire gain if the holder keeps the shares for two years from grant and one year from exercise, though the spread at exercise can trigger alternative minimum tax. NSOs (non-qualified stock options) can go to anyone, including contractors, advisors and directors, and the spread at exercise is taxed as ordinary income. Any ISOs that first become exercisable above $100,000 of value in a calendar year are treated as NSOs.

Most startup option grants are one of two types: incentive stock options (ISOs) or non-qualified stock options (NSOs, also called NQSOs). They look identical on a grant notice and behave very differently at tax time.

ISOs can get capital gains treatment; NSOs create ordinary income at exercise

The core difference is when and how the gain is taxed.

With ISOs, the whole gain can be taxed as long-term capital gain if holding periods are met; with NSOs, the spread at exercise is always ordinary income.

	ISO	NSO
Who can receive	Employees only	Employees, contractors, advisors, directors
Tax at grant	None	None, if priced at fair market value
Tax at exercise	No regular income tax; spread counts for AMT	Spread is ordinary income
Withholding and payroll tax at exercise	No	Yes, for employees
Tax at sale	Long-term capital gain if holding periods met	Capital gain on growth after exercise
Minimum exercise price	Fair market value (110% for 10% owners)	Fair market value in practice, to avoid 409A
Maximum term	10 years (5 years for 10% owners)	Set by the plan
Annual limit	$100,000 first exercisable per year	None
Company reporting	Form 3921	W-2 for employees, 1099 for others

These rules come from Section 422 of the tax code.

ISOs must meet strict conditions to keep their status

An option is an ISO only if it meets all of these:

Granted to an employee of the company or a parent or subsidiary.
Granted under a plan approved by stockholders within 12 months before or after the plan is adopted.
Exercise price at least equal to fair market value on the grant date, or 110% for anyone owning more than 10% of voting power.
Term of no more than 10 years, or five years for 10% owners.
Not transferable except by will or inheritance.
Exercised while employed or within three months after, or one year for a disability.

A 409A valuation is how most private companies establish fair market value. See what a 409A valuation is.

The $100,000 rule turns some ISOs into NSOs automatically

Only $100,000 worth of ISOs can first become exercisable for an employee in any calendar year. Value is measured at the grant-date fair market value, not at exercise.

Any excess is treated as an NSO. The grant is split in two.

Worked example

An employee receives 200,000 options at a $1.00 exercise price, with fair market value of $1.00 at grant. The options vest 25% after one year, then monthly.

Year one: 50,000 options first become exercisable, worth $50,000 at grant. All ISO.
A grant vesting 150,000 options in one year would be worth $150,000. $100,000 ISO and $50,000 NSO.

Vesting acceleration and early-exercisable grants can push more value into a single year. Check the split whenever terms change.

The $100,000 limit counts value when options first become exercisable, using grant-date prices, so larger grants and accelerated vesting are where splits happen.

ISO holders face two tax traps: AMT and disqualifying dispositions

Alternative minimum tax

The spread at exercise (fair market value minus exercise price) is not regular income for an ISO. It is an adjustment for alternative minimum tax. A large exercise can create a large AMT bill with no cash from a sale.

Disqualifying dispositions

To get the full capital gains treatment, the holder must keep the shares at least two years from grant and one year from exercise. Selling earlier is a disqualifying disposition, and the spread at exercise becomes ordinary income.

NSOs are simpler and more flexible

NSOs can go to anyone who provides services. The spread at exercise is ordinary income, and for employees the company withholds income and payroll taxes.

After exercise, any further growth is capital gain, long-term if the shares are held more than a year.

Companies owe Form 3921 for every ISO exercise

For each ISO exercise in a calendar year, the company must:

Give Form 3921 to the employee by January 31 of the following year.
File Form 3921 with the IRS by February 28 on paper, or March 31 if filing electronically.

If the deadline falls on a weekend, it moves to the next business day. Missing it can trigger information return penalties.

Capable handles the split and the filings for you

Capable applies the $100,000 rule automatically when you draft an option grant, creating the ISO and NSO portions with the right amounts. It tracks exercise windows after termination, so ISO status is not lost by accident.

On Growth, Capable prepares Form 3921 for every ISO exercise, including the IRS electronic filing file and the employee copies. It also tracks Rule 701 limits and 83(b) elections.

This guide is general information, not tax advice.

Frequently asked questions

What is the difference between ISOs and NSOs?+

ISOs are available only to employees and can receive long-term capital gains treatment if holding periods are met, with possible alternative minimum tax at exercise. NSOs can be granted to anyone, and the spread at exercise is ordinary income subject to withholding for employees.

What is the $100,000 ISO limit?+

If the fair market value at grant of shares under ISOs that first become exercisable for an employee in one calendar year exceeds $100,000, the excess is treated as NSOs. Value is measured using the fair market value on the grant date.

What are the ISO holding periods?+

To get a qualifying disposition, shares must be held at least two years from the grant date and one year from the exercise date.

Can contractors and advisors receive ISOs?+

No. ISOs are limited to employees. Contractors, advisors and non-employee directors receive NSOs.

What happens to ISOs when an employee leaves?+

To keep ISO tax treatment, the option generally must be exercised within three months after employment ends, or within one year for a disability. Options exercised later are taxed as NSOs.

Does the company file anything for ISO exercises?+

Yes. Form 3921 must be given to each employee who exercised ISOs by January 31 of the following year, and filed with the IRS by February 28 on paper or March 31 electronically.