ISO Vs NSO: Which Stock Option Type Should Your Company Offer?

Before offering equity compensation, many founders hit a wall: Incentive Stock Options (ISOs) and Non-Qualified Stock Options (NSOs), which one should I pick?

It's simple until you realize the tax implications alone could fill a small library. 

Your engineering lead wants equity that won't trigger a surprise tax bill. Your advisor isn't technically an employee, so ISOs are off the table. Your accountant is asking about corporate tax deductions.

However, once you understand the key differences between ISOs and NSOs, the choice becomes much clearer. This guide will break down everything.

Key takeaways: ISO vs NSO for your startup

• The tax advantages make ISOs attractive to key employees who can afford to exercise without liquidity, but they're limited to employees only and come with AMT complexity.
• NSOs offer maximum flexibility. They can be offered to contractors, advisors, and international team members. Plus, any business structure can offer NSOs, unlike ISO, which can only be issued by C-corporations.
• ISOs defer employee taxes but provide no company deduction, while NSOs create immediate employee taxes at exercise but give companies tax benefits.
• Some prefer ISO tax advantages despite AMT risks, others value NSO simplicity and immediate tax clarity over potential savings.

TL;DR ISO vs NSO

What is ISO? 

Incentive Stock Options (ISOs) are a type of tax-advantaged stock option that gives employees the right to buy company shares at a fixed price in the future. What sets ISOs apart from other forms of equity compensation is how they’re taxed.

Handled correctly, ISOs can result in significantly lower taxes for employees through long-term capital gains treatment on the overall gain (sale price – strike price) and no taxes at exercise.

Here's how ISOs work: You set an exercise price equal to your company's current fair market value (FMV), with a vesting schedule. Employees can then buy shares at this locked-in price, even if your company's value increases over time. This fixed price is called the exercise price or strike price. 

But ISOs come with strict IRS rules:

• Employees can only receive ISOs worth up to $100,000 per calendar year, based on FMV at the grant date. Anything beyond this becomes a non-qualified stock option (NSO).
• The exercise price must equal or exceed the stock's FMV when granted. 
• If an employee owns more than 10% of your company, their exercise price must be 110% of FMV, and they have only five years from the grant date to exercise.
• Only C corporations can grant ISOs. 

What is NSO?

Non-Qualified Stock Options (NSOs) are stock options that don't meet the IRS requirements for special tax treatment.

While they work similarly to ISOs (giving recipients the right to buy shares at a fixed price), they are more straightforward :

• Any business structure can grant NSOs: corporations, LLCs, and partnerships. 
• Unlike ISOs' $100,000 annual cap, NSOs have no restrictions on grant value.

NSOs are also more common among startups because they can be granted to anyone: employees, consultants, directors, advisors, or contractors, whereas ISOs are limited to employees only. 

Tax treatment of ISO Vs NSO

Here’s the breakdown of the tax treatment for each option type for better startup equity decisions.

How are ISOs taxed?

ISOs get special tax treatment, provided certain conditions are met. 

At exercise: 

When employees exercise ISOs, they typically don't owe regular income tax immediately. 

But there's a catch: the difference between their exercise price and the stock's FMV may get added to the Alternative Minimum Tax (AMT) calculation (we'll cover AMT details in the next section).

At sale: 

Here, we have two different tax scenarios.

Qualifying disposition (Best tax treatment) 

To get the favorable tax treatment through a qualifying disposition, the employees must hold shares for:

• At least two years from the grant date, and
• At least one year from the exercise date

When both conditions are met, the entire gain gets taxed as long-term capital gains  (currently 0%, 15%, or 20% depending on your income).

Example: Your employee receives ISOs in January 2022 with a $5 strike price. They exercised in March 2023 when shares were worth $25. And, they sell in April 2024 for $40 per share.

Since they held the ISOs for two years from the grant and one year from the exercise, the $35 gain per share ($40 sale price minus $5 strike price) gets taxed as long-term capital gains.

Note: With qualifying dispositions, your company gets no tax deduction.

Disqualifying disposition (Less favorable treatment) 

If your employee sells before meeting either holding requirements, the tax treatment changes. The difference between the FMV at exercise and the strike price becomes eligible for ordinary income tax. Any additional gain above the exercise-date value gets taxed as capital gains.

Example: Say, the employee sells in December 2023 instead. The $20 per share difference between exercise value and strike price becomes ordinary income (taxed at the regular income tax rate). The remaining $15 gain ($40 sale price - $25 FMV at exercise) gets taxed as short-term capital gains.

Note: With disqualifying dispositions, your company can claim a tax deduction equal to the ordinary income portion that the employee recognizes.

Impact of AMT on ISOs

Alternative Minimum Tax (AMT) is where ISOs can create an unexpected tax bill for your employees. AMT is a parallel tax system that ensures high earners pay a minimum tax amount, regardless of deductions.

When employees exercise ISOs, the difference between the fair market value (FMV) and the strike price is added to their income for Alternative Minimum Tax (AMT) purposes. If their AMT liability exceeds regular income tax, they must pay the difference as additional tax.

Example: An employee exercises ISOs with a $5 strike price when shares are worth $30. The $25 per share gets included in their AMT calculation, potentially triggering AMT liability even though they haven't sold anything yet.

But the good news is that when employees eventually sell the shares in a qualifying disposition, they may be eligible for an AMT credit. But the timing mismatch between owing AMT and receiving the credit can be painful.

Your employees should consult tax professionals before exercising large ISO grants to model potential AMT exposure and plan accordingly.

What happens when employees leave?

When employees leave your company, they typically have a limited post-termination exercise period (PTEP) to exercise their vested ISOs, usually 90 days.

After 90 days, vested ISOs either lapse (if your company follows the typical deadline) or shift to NSO tax treatment (if your plan includes an extended exercise window).

Organizations that extend the exercise window beyond the standard 90-day period allow greater flexibility for former employees. Still, this flexibility comes at a cost — the options lose their preferential ISO tax treatment and are instead taxed under NSO rules. 

How are NSOs taxed?

NSOs get taxed twice: when exercised and when sold. Unlike ISOs, there's no special tax treatment or complicated holding periods to worry about.

At exercise:

When employees exercise NSOs, they immediately owe ordinary income tax on the "spread" (the difference between the strike price and the FMV at exercise). This gets treated as regular wages and is subject to income tax and payroll taxes.

You’ll withhold these taxes from your employees and can also charge the withholding costs during the purchase. 

At sale:

When employees sell the shares, any gain above the FMV at exercise gets taxed as capital gains:

• Short-term capital gains if sold within one year of exercise
• Long-term capital gains if held for more than one year after exercise

Example calculation: An employee receives NSOs in 2022 with a $8 strike price. They exercise in 2024 when shares are worth $35, then sell in 2025 for $50.

At exercise (2024):

• Ordinary income: $27 per share ($35 FMV - $8 strike price)
• Taxed at the employee's regular income tax rate

At sale (2025):

• Capital gains: $15 per share ($50 sale price - $35 exercise FMV)
• Since held over one year, taxed at long-term capital gains rates 

Companies get a tax deduction equal to the ordinary income your employee recognizes at exercise ($27 per share in this example). From a tax perspective, this deduction often makes NSOs more attractive to companies than ISOs.

Impact of AMT on NSOs

NSOs have a significant advantage over ISOs when it comes to the Alternative Minimum Tax: they're not subject to it at all.

For your employees, this means no surprise tax bills when filing returns, no need to set aside extra cash for potential AMT liability, and no complex calculations about exercise timing to minimize AMT exposure.

ISO Vs NSO: Which one should you offer?

The choice between ISO vs NSO isn't one-size-fits-all and depends on several factors unique to your situation like:

• Your company's objectives
• Impact on taxes
• Company structure and growth stage
• Timing requirements and flexibility including exercise deadlines and holding periods for tax benefits
• Employee demographics
• Operational complexity and cost

When to choose ISO

Based on these considerations, let's look at specific scenarios where ISOs make the most sense. 

For key employee retention: Most employees prefer ISO plans because of the tax benefits they offer. However, they should be reserved for high-value employees like executives and managers, where the retention impact justifies the administrative complexity.

When you're hiring employees: ISOs are only eligible for individuals who are employees. If you're granting options exclusively to your employee base and not to contractors or advisors, ISOs become a viable choice.

When your company can handle the structure: Choose ISOs when your company can manage the administrative requirements and don't need the immediate tax deduction that comes with NSOs.

When to choose NSO

NSOs are more widely used and common than ISOs because they offer greater flexibility for companies in various situations.

For non-employee contributors: When issuing stock options to non-employees, NSOs are your only choice. This includes consultants, board members, mentors, and other service providers who contribute to your company's success but aren't on your payroll.

When you want tax deductions: NSOs allow companies to take tax deductions when employees exercise their options. Since NSO earnings are viewed as income for the employee, you get the corresponding tax deduction. This financial benefit can be significant for companies.

For operational simplicity: When looking for a simpler and straightforward stock option to offer employees, NSOs win. They don't have the complex holding period requirements, $100,000 annual limits, or strict IRS compliance rules that come with ISOs.

Summing up

Employee stock options remain one of the most powerful tools for building a motivated and aligned team. The ISO vs NSO decision ultimately comes down to matching your choice to your company's structure, goals, and team composition.

Getting this right means your employees win through meaningful equity participation, and your company wins through aligned incentives and potential tax benefits. Take time to understand these differences, communicate them clearly to your team, and consider consulting professionals for complex situations.

Managing stock options just got easier

As your team exercises ISOs and NSOs, your stock option management becomes increasingly complex. EquityList helps you digitize and track every stock option exercise, manage cross-border entities, and model fundraising scenarios — in one dashboard. Stay audit-ready from grant to exit. 

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ISO vs NSO FAQs for startup founders

1. Which is better, ISO or NSO?

There's no universal "better" option; it depends on your company’s situation. ISOs offer better tax treatment for employees but come with strict rules and eligibility limits. NSOs provide more flexibility for companies but create immediate tax burdens for employees when exercised.

2. Can you convert ISO to NSO?

You can't directly convert granted ISOs to NSOs. However, ISOs automatically become NSOs if they do not meet specific requirements. Say, if they exceed the $100,000 annual limit or if employees don't exercise them within 90 days of leaving the company.

3. What is the $100,000 rule for ISO?

The $100,000 rule limits employees to no more than $100,000 worth of ISOs that can become exercisable in a single calendar year, based on the fair market value at the time of grant. Any amount above this threshold automatically converts to NSOs under IRS rules.