How incentive stock options (ISOs) differ from non-qualified stock options (NSOs): tax treatment, eligibility, exercise strategy, and when each fits.
ISO vs NSO is one of the most consequential tax distinctions in a startup's cap table. Grant the wrong type and employees pay double or triple the tax they otherwise would.
Available only to employees (not advisors or contractors). No ordinary income tax at exercise if held long enough. If shares are held >2 years from grant and >1 year from exercise, the entire gain is taxed at long-term capital gains rates.
Available to anyone — employees, advisors, contractors, consultants. Ordinary income tax due at exercise on the spread between strike price and fair market value. Additional capital gains treatment on later appreciation.
The spread at exercise, while not counted for regular tax, IS counted for Alternative Minimum Tax. Employees exercising large ISO grants can trigger substantial AMT bills without any liquidity to pay them. Model this before exercising.
Only $100,000 worth of ISOs (measured by strike price) can first become exercisable per employee per year. Grants exceeding this threshold convert to NSO treatment for the excess.
Both types can be early-exercised if the plan allows. Combined with an 83(b) election within 30 days, early exercise starts the capital gains holding clock immediately and minimizes future tax exposure. Best done when strike price and fair market value are equal (right after grant).
Default to ISOs for employees up to the $100K limit. NSOs for advisors, contractors, and any grant above the ISO limit. Nearly all option plans support both — the classification happens per grant.
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