ISO vs NSO Tax

ISO vs NSO Tax: One Grant Decision, Two Tax Systems

ISOs and NSOs are taxed differently at exercise. For an employee, the NSO spread is wages, with federal income tax withholding and FICA due; the ISO spread is not regular taxable income at exercise, carries no withholding, and can enter the alternative minimum tax calculation instead.

Written by the

Slice Global equity team

Last updated

October 2026

TL;DR

The short version, by stage.

Who can hold it: ISOs go to employees of the granting company or its parent or subsidiary. NSOs can go to anyone: employees, contractors, advisors, directors.

At exercise: an employee's NSO spread is supplemental wages, with withholding and FICA. An ISO spread carries no regular federal income tax and no withholding; for vested shares held past the exercise year, it is an AMT adjustment.

At sale: ISO shares held 2 years from grant and more than 1 year from exercise get long-term capital gain treatment on the whole gain over the strike. NSO shares get capital treatment only on growth after exercise.

The employer side: an NSO exercise means wage reporting and a corporate deduction. An ISO exercise means a Form 3921 and generally no deduction, unless the holder later makes a disqualifying disposition.

The $100K limit: ISOs first exercisable in a calendar year above $100,000 of grant-date value, counted across the employee's ISOs under the issuer's plans and those of its parent and subsidiaries, are treated as NSOs.

In one customer case reviewed by the Slice team, 341,100 options among 581,504 exercisable options that had been treated as ISOs required NSO treatment, because the $100K limit had not been applied. NSOs carry withholding at exercise, so the NSO portion needed its own withholding and W-2 analysis.

The two letters on a grant decide who pays what, when, and which payroll obligations land on the company. This guide covers what separates the two, how each is taxed from grant to sale, what an NSO exercise withholds, the $100K limit that turns one into the other, what the employer reports and deducts, and how companies choose.

What is the difference between an ISO and an NSO?

An incentive stock option (ISO) is a statutory option under Section 422 of the Internal Revenue Code. It can go only to employees, and when its conditions are met, exercising it creates no regular federal income tax. A nonqualified stock option (NSO) is any option that does not meet those conditions. It can go to anyone, and its spread at exercise is ordinary income.

The two side by side:

ISO

NSO

Who can hold it

Employees of the granting company or its parent or subsidiary

Employees, contractors, advisors, directors

Tax at grant

None, with the strike at or above grant-date fair market value

Regular federal income tax at exercise

None

The spread is ordinary income

AMT at exercise

The spread is an AMT adjustment for vested shares held past the exercise year

No AMT adjustment

Withholding and FICA at exercise

None

For employees, yes; for non-employees, no wage withholding or FICA

Tax at sale

Long-term capital gain on the whole gain over the strike, if both holding periods are met

Capital treatment on growth after exercise

Employer reporting

Form 3921 for each exercise

Form W-2 (code V) for employees, Form 1099-NEC for non-employees

Employer deduction

None, unless a disqualifying disposition occurs

The spread, at exercise

Annual limit

$100,000 of grant-date value first exercisable per calendar year

None

ISO requirements: what keeps an option an ISO

An option is an ISO only while every condition holds, and failing one means NSO treatment. The conditions sit at three levels: the plan, the grant, and the holder's employment.

Level

Condition

Plan

Written plan stating the share count and the eligible employee class, approved by stockholders within 12 months before or after adoption; ISO grants only within 10 years of adoption or approval, whichever is earlier

Grant

Strike at or above grant-date fair market value (110 percent for a holder of more than 10 percent of the voting power); term of 10 years or less (5 years for that holder)

Holder

An individual employee, employed continuously from the grant date through 3 months before exercise (1 year where the termination is for disability)

Annual cap

Grant-date value first exercisable in a calendar year above $100,000 is treated as an NSO

The employment test is the one that moves after grant. A post-termination exercise window longer than 3 months does not cancel the option; an exercise after the third month (or after 1 year, where the termination is for disability) gets NSO treatment. An employer-of-record arrangement does not by itself create that employment relationship; ISO eligibility turns on who employs the person and on the corporate structure.

ISO vs NSO tax at grant, exercise and sale

A qualifying ISO and an NSO priced at fair market value generally produce no tax at grant or at ordinary vesting. The exceptions are an NSO with a readily ascertainable value at grant, and a discounted NSO that falls under Section 409A and fails it. The difference opens at exercise and closes, or does not, at sale.

At grant. No tax for either, provided the strike is at or above the grant-date fair market value. An option struck below it cannot be an ISO. As a compensatory option subject to Section 409A it generally fails the stock-right exemption, and if it does not comply the holder can face income at vesting, a 20 percent additional federal tax and premium interest.

At exercise. The spread is the fair market value on the exercise date minus the strike, and it lands three different ways:

An employee's NSO: supplemental wages. The company withholds federal income tax and FICA and reports the income on the W-2 with code V.
A US contractor's NSO: generally reported on Form 1099-NEC, with no wage withholding and no FICA, though backup withholding can apply.
An ISO: no regular federal income tax and nothing withheld. For vested shares held past the end of the exercise year, the spread counts as income for the AMT, covered with the 2026 numbers in the AMT and stock options guide.

At sale. NSO shares take a basis equal to the fair market value taxed at exercise, so only later growth gets capital treatment, long-term once held more than a year after exercise.

ISO shares held 2 years from grant and more than 1 year from exercise make a qualifying disposition: the whole gain over the strike is long-term capital gain.

A sale before both periods are met is a disqualifying disposition, and the spread at exercise is generally ordinary income, with any further gain treated as capital gain. If an arm's-length sale lands below the exercise-date value, the ordinary income is limited to the actual gain.

One structure needs separate treatment: the net exercise of ISOs. Where net exercise was in the option's original terms, advisers commonly split the shares two ways:

The shares netted to cover the exercise: a deemed disqualifying disposition, with ordinary income on them.
The remaining shares: they can retain ISO treatment if the other conditions are met, and their spread stays in the AMT lane.

The Code and regulations do not expressly settle this treatment, so it is adviser practice rather than statute, and the two halves should not be collapsed into one. Adding net exercise to an option later needs its own modification analysis.

How much is withheld on an NSO exercise?

For an employee's NSO, the spread is supplemental wages and runs through the same federal withholding rules as a bonus. The 2026 figures:

What is withheld

Rate

Where it applies

Federal income tax, flat method

22 percent

Supplemental wages up to $1,000,000 in the year

Federal income tax, mandatory

37 percent

Supplemental wages above $1,000,000 in the year, regardless of the W-4

Social Security

6.2 percent employee, 6.2 percent employer

Wages up to the 2026 wage base of $184,500

Medicare

1.45 percent employee, 1.45 percent employer

All wages, no cap

Additional Medicare

0.9 percent, employee only

Wages above $200,000

The 22 percent flat rate is a withholding method, not the holder's final federal income tax. Where the flat method is available and chosen, its rate applies; otherwise the employer uses the aggregate method.

The final figure comes from the full return, so the flat method can leave a balance due. The table covers federal withholding; state and local withholding can add to it. An ISO exercise has none of these lines: no federal income tax withholding, no Social Security, no Medicare.

The $100K ISO limit: how an ISO becomes an NSO

The $100K limit is where the two instruments meet. ISOs that first become exercisable in a calendar year above $100,000 of value are treated as NSOs. Three details decide the outcome:

The value is grant-date fair market value, not the value at exercise and not the strike paid.
The count is cumulative, across the employee's ISOs under the issuer's plans and those of its parent and subsidiaries.
The test runs on when options first become exercisable, so a vesting schedule, a cliff or an acceleration can move value into one year.

The limit does not cap vesting. The options still vest; the excess is an NSO, with NSO withholding at exercise. Two events move the math in ways that are easy to miss:

Acceleration after termination: the accelerated options become exercisable at once, and they count toward that year's $100,000.
A repricing treated as a modification: it is a new ISO grant, retested at grant-date fair market value against only the headroom that remains for that year, with ISO eligibility reassessed. A former employee's repriced award cannot simply become a new ISO. In many cases, part of the award loses ISO treatment as a result.

Slice's guide to the $100K ISO limit walks through the split.

Practice note. Calculate and record the expected $100K split at grant, run cumulatively across the holder's ISOs, then update it if a later change, such as acceleration or a repricing, moves shares into a different first-exercisable year. The classification decides whether payroll withholds when the option is exercised, and payroll can only withhold on what the equity record tells it.

What the employer reports and deducts for ISOs and NSOs

The company's paperwork follows the instrument. Three outputs, three different forms:

NSO, employee: the spread is wages on the W-2, code V, with withholding at exercise. The company generally deducts the amount the holder includes, in the matching year, subject to the usual deduction rules.
NSO, non-employee: for a US contractor, the spread is generally reported on Form 1099-NEC, with no wage withholding and no FICA, though backup withholding can apply.
ISO: a Form 3921 for each reportable ISO share transfer by a current or former employee, one form per transaction, apart from the nonresident alien exception, with copies to the employee by January 31 and the IRS filing by February 28 on paper or March 31 electronically. E-filing is mandatory at 10 or more information returns in aggregate, and W-2s count toward that total.

An ISO generally produces no corporate deduction. A disqualifying disposition changes that: the ordinary income lands in W-2 box 1 as wages, with no income tax withholding, no FICA and no code V. The company may need its own way to learn of the disposition.

ISO vs NSO for companies granting across borders

A non-US parent can grant ISOs without meaning to. If its grant to an employee of a qualifying US subsidiary meets every Section 422 requirement, the options can be ISOs even without the label; an express NSO designation changes that.

The company then does not get the deduction it expected from an NSO exercise, because an ISO gives a deduction only on a disqualifying disposition. For a cross-border cap table, the plan document deserves a deliberate answer either way.

The reverse direction matters too. ISO status is a US federal tax status. When a holder moves to another country, the US treatment can survive while the new country taxes the exercise under its own rules, covered in what happens to equity when employees move countries. The wider picture is in granting stock options to foreign employees.

ISO or NSO: how companies choose

Neither option is better in the abstract. The choice turns on who the holder is, where they pay tax, and how much ISO headroom remains under the $100K limit.

Option

Where it fits

The limitation

ISO

US-taxed employees who may hold shares through both holding periods

AMT can apply at exercise with nothing withheld; the $100K limit caps the annual value; every condition must keep holding; generally no corporate deduction

NSO

Contractors, advisors, directors, grantees outside the US tax net, and value above the $100K headroom

Tax at exercise on shares that may not be sellable; withholding the company must collect and remit

Two numbers are worth running both ways before a grant: the holder's tax under each instrument, and the company's deduction under each. The Equity Value Simulator estimates tax outcomes for planning; its estimates are informational, not tax advice.

Where Slice fits

The ISO/NSO line is drawn at grant, and the employment test is checked again at exercise, so the classification has to live in the equity record rather than in a spreadsheet beside it.

Slice flags a grant that crosses the $100K ISO limit, displays the ISO/NSO breakdown, and provides an ISO/NSO Split Grants ($100K Threshold) report across the holder's grants. For NSO exercises, Slice captures and tracks withholding through the exercise workflow; for ISO exercises, it prepares the Form 3921 data for filing.

The same record holds grants across 67+ countries, so a US employee's ISOs and a contractor's NSOs abroad sit in one cap table. When an employee moves countries and the company uses a supported HRIS, the sync proposes the change for admin review and the equity record follows. Your team enters or approves every fact, and filing stays in your hands.

FAQ

Frequently asked questions

Can contractors receive ISOs?

No. ISOs are limited to employees of the granting company or its parent or subsidiary. Contractors, advisors and non-employee directors receive NSOs, and a US contractor's NSO exercise is generally reported on Form 1099-NEC, with no wage withholding and no FICA, though backup withholding can apply.

Can an ISO turn into an NSO?

Yes. An option keeps ISO treatment only while every condition holds. The common ways it gets NSO treatment instead:

Value first exercisable in a calendar year above the $100,000 limit.
An exercise more than 3 months after employment ends (1 year where the termination is for disability).
A plan or grant that misses a requirement, such as stockholder approval within the 12-month window.
A repricing that leaves too little $100K headroom for the new grant.

Do NSOs trigger the alternative minimum tax?

Not directly. An NSO spread is ordinary income in both the regular and the AMT calculation at exercise, so there is no AMT adjustment to make, though like any income it counts toward AMTI. The AMT question is an ISO question, covered in the AMT and stock options guide.

Is a disqualifying disposition reported on Form 3921?

No. Form 3921 reports the exercise itself. If the holder later sells before both holding periods are met, the ordinary income goes in W-2 box 1 as wages, with no income tax withholding, no FICA and no code V.

Does an 83(b) election apply to ISOs or NSOs?

Not to the option grant. A standard option transfers no stock, so there is nothing to elect on. The election becomes relevant only when an option is early-exercised into shares that are still vesting, and early-exercised ISOs follow separate rules, covered in the 83(b) election guide.