ISO vs NSO: Understanding Stock Option Types

Companies commonly compare two types of compensatory stock options: incentive stock options (ISOs) and nonqualified stock options (NSOs, sometimes called NQSOs). Both give the holder the right to buy company shares at a fixed exercise price. The difference is in who can receive them, how they are taxed, and how much work they create for the company. This guide compares the two and covers what each one means for plan design and administration.

ISO vs NSO at a Glance

What Are Incentive Stock Options?

ISOs are defined by Section 422 of the Internal Revenue Code. They receive favorable tax treatment, but only when a long list of requirements is met. Among them:

• They can only be granted to employees, not to directors or contractors.
• They must be granted under a plan approved by shareholders, within 10 years of the plan’s adoption or approval.
• The exercise price must be at least the fair market value of the stock on the grant date, and the option term can’t exceed 10 years. For holders of more than 10% of the company’s voting power, the price must be at least 110% of fair market value and the term can’t exceed 5 years.
• The stock covered by ISOs that first become exercisable for an employee in any calendar year can’t exceed $100,000, measured at grant-date value. Anything above that limit is automatically treated as an NSO.

How ISOs Are Taxed

When an employee exercises an ISO, there is no regular income tax and no payroll tax. For shares that are vested at exercise, the spread between the exercise price and the stock’s fair market value is generally an adjustment for the alternative minimum tax (AMT), unless the shares are sold in the same year. That can create a tax bill even though the employee hasn’t sold anything.

If the employee holds the shares for more than two years from the grant date and more than one year from the exercise date, the sale is a qualifying disposition and the entire gain is taxed as a long-term capital gain for regular federal income tax. If they sell earlier, it is a disqualifying disposition: gain up to the spread at exercise is generally ordinary income, and the company may take a matching deduction.

ISO status also depends on timing after employment ends. An option generally must be exercised within three months of termination (one year for disability) to keep ISO treatment. Exercises after that window are taxed as NSOs.

What Are Nonqualified Stock Options?

NSOs do not have to meet the ISO requirements. That flexibility is the main reason companies use them. NSOs can be granted to anyone who provides services to the company, they have no annual limit, and companies can set their own terms for vesting and post-termination exercise windows.

How NSOs Are Taxed

For a typical NSO without a readily determinable value at grant, the spread between the exercise price and fair market value is ordinary income when the shares are vested at exercise. For employees, it is treated as wages: the company withholds income tax and FICA and reports the income on Form W-2. For non-employees, the income is reported on Form 1099-NEC. Any growth after exercise is taxed as a capital gain when the shares are sold, long-term if they are held for more than a year.

Because the holder recognizes income at exercise, the company gets a tax deduction for the same amount, which is one of the reasons NSOs are common for executives and at later-stage companies.

NSOs should still be granted at fair market value. Options granted below fair market value can fall under Section 409A, which brings additional taxes and penalties for the holder. Private companies typically rely on an independent 409A valuation to set the exercise price for both option types.

Which Stock Option Type Should a Company Grant?

Many companies use both. ISOs are common for employees at startups and private companies, where the potential for long-term capital gains treatment is a meaningful recruiting tool. NSOs are the default for directors, advisors, consultants, and employees outside the US, and for any grants above the $100,000 ISO limit.

Questions to work through include who the company needs to grant to, whether it values the tax deduction NSOs provide, whether employees are likely to hold shares long enough to benefit from ISO treatment, and whether the company wants to offer an extended post-termination exercise window, which would turn ISOs into NSOs after three months anyway. Our plan and process design work helps companies answer these questions before grants go out.

What Each Option Type Means for Administration

The two option types create different workloads for the equity team, payroll, and tax:

• ISO limit tracking. The $100,000 limit has to be checked each year for every employee, and the portion over the limit must be split out as NSOs in the equity platform.
• Form 3921 reporting. Most ISO exercises require a Form 3921, due to employees by January 31 of the following year. Our Section 6039 reporting guide covers the process.
• Disqualifying dispositions. The company needs to know when employees sell ISO shares early so the ordinary income is reported on the W-2 and the deduction is captured.
• NSO withholding. Each NSO exercise by an employee triggers payroll withholding, which requires timely data from the equity platform or broker to payroll.
• Status changes. Terminations, leaves of absence, and plan or grant modifications can convert ISOs to NSOs, and the records need to reflect it.

Errors in any of these areas lead to incorrect tax reporting and frustrated employees. Accelerated Equity Plans provides stock plan administration for companies granting ISOs, NSOs, or both, including limit tracking, exercise processing, payroll coordination, and year-end reporting.

This article is general information, not tax or legal advice. Talk with your tax advisor or counsel about how these rules apply to your company and employees.