How Stock Options Are Taxed: ISO vs NSO Tax Treatments

How stock options are taxed: A complete guide

Author:

Shelby Whitefield, CPA

Learn about stock options taxes, including the tax treatment differences between ISOs and NSOs, holding periods, exercising, and the alternative minimum tax.

A stock option is a type of equity that allows employees and other service providers to buy a set number of shares in the company at a fixed price, called a strike price or exercise price. Your purchase price stays the same over time, so if the value of the stock goes up, you could make money on the difference, called the spread. You may also have to pay taxes on that spread.

The two main types of stock options are incentive stock options (ISO) and non-qualified stock options (NSO). The primary difference between them is how they are taxed, as ISOs could qualify for favorable tax treatment.

How are stock options taxed?

Stock options are typically taxed at two points in time: first when they are exercised and again when they’re sold. According to the IRS, you may receive income when you receive an option, when you exercise it, or when you sell the resulting shares of stock. The specific tax consequences of exercising stock options depend entirely on whether they are ISO or NSO. The tax implications at each stage differ significantly between the two.

ISO vs. NSO


Feature	Incentive stock options (ISO)	Non-qualified stock options (NSO)
Who can receive them	Employees only	Employees, contractors, and advisors
Tax at exercise	No regular income tax, but may trigger alternative minimum tax (AMT)	Ordinary income tax on the spread between exercise price and FMV
Tax at sale	Gain is taxed as capital gain for qualifying dispositions	Gain is taxed as a capital gain

Taxation at exercise

When you exercise your stock options, your potential tax liability is determined by the difference between your strike price (fixed purchase price) and the current fair market value (FMV) of those stock options.

For NSOs, the moment of exercise creates a clear taxable event. The spread is taxable as ordinary income and your company will usually withhold taxes (including federal, payroll, and any applicable state taxes) on the spread when you exercise.
For ISOs, there is no regular income tax due at exercise. Instead of the spread being includable in ordinary income tax, it is included as income in something called the alternative minimum tax (AMT) calculation, which could trigger additional taxes owed when you file your tax return.

Taxation at sale

When you sell your company stock, you are taxed on any increase in value you realized on your investment. This gain can be taxed as either ordinary income or capital gains depending on the type of option and your holding period, which is how long the employee owns the shares after exercising them. If you hold the shares for a year or less, the profit is typically taxed at higher short-term capital gains rates. If you hold them for more than a year, the profit may be taxed at lower long-term capital gains rates.

How incentive stock options are taxed

ISOs are a type of stock option that can qualify for special tax treatment. Unlike with NSOs, you only sometimes have to pay taxes when you exercise ISOs. While ISOs offer the potential for a more favorable tax outcome, they come with specific rules that both the company and the employee must follow.

ISO taxation at exercise: Alternative minimum tax

Depending on when you exercise your options and the spread at exercise, the AMT may impact your taxes owed.

The AMT is a parallel tax system defined by the IRS as a separate tax imposed in addition to your regular tax.

ISO taxation at sale: Qualifying and disqualifying dispositions

When an employee sells shares they acquired from an ISO exercise, the sale is classified as either a qualifying or disqualifying disposition.

Qualifying disposition: This occurs when an employee sells their shares at least two years after the grant date and at least one year after the exercise date.
Disqualifying disposition: This happens if an employee sells their shares before meeting both holding period requirements.

How non-qualified stock options are taxed


Action	Tax implication
You exercise your NSOs	You’ll likely pay ordinary income tax on the difference between your strike price and the current market price of the stock
You exercise and sell your NSOs in one transaction	You’ll likely pay ordinary income tax on the difference between your strike price and the current market price of the stock
You sell your NSOs within a year of exercising	You’ll likely pay short-term capital gains taxes on the profit you made selling your options
You sell your NSOs after holding them for at least a year	You’ll likely pay long-term capital gains taxes on the profit you made selling your options

Your company’s tax withholding obligation

When an employee exercises NSO, your company is legally required to withhold ordinary income and payroll taxes, such as Social Security and Medicare, on the spread.

Capital gains tax vs. ordinary income tax for stock options

There are two types of taxes you need to keep in mind when dealing with your options: ordinary income tax and capital gains tax.

Capital gains tax for stock options

You’ll likely pay capital gains tax on a portion of the profit when you sell stock you have previously exercised. For tax purposes, there are two types of capital gains:

Short-term capital gains: If you have held the stock for one year or less from the date of exercise
Long-term capital gains: If you have held the stock more than one year from the date of exercise

Ordinary income tax for stock options

If a portion of your taxable gain is subject to ordinary income tax, you will be taxed at the same rate as the rest of your ordinary income based on your taxable income, filing status, and tax bracket.

How to plan for stock option taxes

When you exercise your stock options, gains are not guaranteed. All investment decisions, including whether or not to exercise, carry risk. Reach out to a CPA, professional tax advisor, or legal advisor to understand your options.

Your company’s tax reporting responsibilities

Issuing equity is a sign of a growing company, but it also comes with specific IRS reporting requirements. As a founder, running a professional and compliant company builds trust with investors, auditors, and employees.

Form 3921 for ISO exercises

Your company must file this form with the IRS for each transfer of stock to an employee who exercised an ISO during the tax year.

W-2 reporting for NSO exercises

The ordinary income an employee recognizes from an NSO exercise must be included as wages on their Form W-2 for that year.

Helping your team make smart equity decisions

Helping employees understand their ownership is a common challenge for leaders at growing companies. This is where a dedicated service can bridge the gap. Speak to an expert to learn how Carta Equity Advisory can help your team make informed decisions.

Frequently asked questions about stock option taxes

What is the $100,000 rule for ISO?

For any employee, only the first one hundred thousand dollars worth of ISO that become exercisable in a single calendar year can receive the special ISO tax treatment.

Can employees reduce taxes with qualified small business stock?

Qualified small business stock (QSBS) is a U.S. tax incentive that may allow shareholders to exclude some or all of their capital gains from federal tax when they sell their shares.

Are stock options taxed twice?

NSOs are taxed at two different times on two different types of gains. You first pay ordinary income tax on the spread at the time of exercise, and then pay a second time as a capital gain on any additional profit when the shares are eventually sold.