Pre-IPO Stock Options: ISOs vs NSOs, and How Each Is Taxed

Incentive stock options (ISOs) and nonqualified stock options (NSOs) can sit in the same award, carry the same strike price and vest on the same schedule, yet produce different tax bills at exercise and at sale. Below is how each works under 2026 federal rules, where the $100,000 limit turns ISOs into NSOs, what happens when you leave, and the California layer. Confirm your own numbers with a CPA before you exercise.

What is the difference between an ISO and an NSO?

Both are rights to buy company stock at a fixed price for a fixed period; the difference is the section of the tax code that governs them. An ISO is a “statutory” option that meets the conditions of Internal Revenue Code section 422: granted under a shareholder-approved plan, only to an employee, with a strike price at least equal to the stock’s fair market value on the grant date and a term of no more than 10 years (26 U.S.C. §422(b)). An NSO is any option that does not meet those conditions, which is why contractors, advisers and board members receive NSOs, and why an ISO that breaks a condition later is taxed as an NSO (IRS Topic 427).

The reward for meeting the ISO conditions is the possibility of no ordinary income at all: hold the shares long enough and the entire gain from the strike price to the sale price is a long-term capital gain. The cost is a second tax calculation, the alternative minimum tax (AMT), at the moment you exercise. NSOs are simpler: the spread is wages when you exercise, taxed and withheld like a bonus.

How is an NSO taxed at grant, exercise and sale?

An NSO is taxed once at exercise, as wages, and again at sale, as capital gain. Nothing happens at grant for an option without a readily ascertainable market value, which describes nearly every private-company option (26 U.S.C. §83(e)(3)).

• Exercise. The spread, meaning the fair market value of the shares on the exercise date minus what you paid for them, is ordinary compensation income. Your employer reports it on Form W-2 and withholds income tax, Social Security and Medicare on it (IRS Publication 525, Stock Options). Federal withholding on supplemental wages is typically a flat 22% up to $1 million in a year and a required 37% above that (IRS Publication 15 (2026), section 7), so a large exercise by someone in the 32% or 35% bracket is under-withheld and produces a bill in April.
• Basis. Your basis in the shares becomes the fair market value on the exercise date, because you have already paid tax on the spread.
• Sale. Any change in value after exercise is capital gain or loss. It is long-term if you held the shares more than one year after exercise; the grant date does not matter for an NSO.

Because the tax is due at exercise whether or not you can sell the shares, an NSO exercise at a private company means writing two checks, one for the strike price and one for the tax, in exchange for shares you may not be able to sell for years.

How is an ISO taxed at grant, exercise and sale?

An ISO produces no regular taxable income at grant or at exercise; the tax arrives at sale, and its character depends on how long you held the shares. Exercise does count for the AMT.

• Exercise, regular tax. Section 421 provides that no income results when you exercise a statutory option, and your employer gets no deduction (26 U.S.C. §421(a)). Your regular-tax basis is what you paid: the strike price.
• Exercise, AMT. For the alternative minimum tax the ISO is treated as if it were an NSO: the spread on the exercise date is an adjustment that increases alternative minimum taxable income in the year of exercise, unless you sell the shares in that same year (26 U.S.C. §56(b)(3)). Your AMT basis in the shares is the fair market value at exercise. Whether the adjustment produces an actual AMT bill depends on the rest of your return; the 2026 exemption for a married couple is $140,200 (IRS, tax year 2026 inflation adjustments), and our companion article on exercising ISOs before an IPO works through the arithmetic.
• Form 3921. Your employer files Form 3921 for each ISO exercise and gives you a copy (IRS, About Form 3921); it records the dates, strike price, fair market value and share count that set your basis and start the holding-period clocks.
• Qualifying sale. Sell more than two years after the grant date and more than one year after the exercise date, and the whole gain from strike to sale price is long-term capital gain (26 U.S.C. §422(a)(1)). For 2026, a married couple pays 15% on long-term gains until taxable income passes $613,700 and 20% above that (Rev. Proc. 2025-32, section 4.03), plus the 3.8% net investment income tax where it applies (26 U.S.C. §1411).
• Disqualifying sale. Sell before either date and the spread on the exercise date becomes ordinary income in the year of the sale (26 U.S.C. §421(b)). The employer reports it as wages but is not required to withhold on it. If the shares fell below the exercise-date value before you sold, the ordinary income is limited to your actual gain (26 U.S.C. §422(c)(2)). Anything above the exercise-date value is capital gain, short- or long-term depending on how long you held the shares after exercise.

What is the $100,000 ISO limit, and why are some ISOs really NSOs?

Only $100,000 of options, valued at the grant-date price, can first become exercisable in any one calendar year and still be ISOs; the excess is treated as NSOs (26 U.S.C. §422(d)). The test uses fair market value on the grant date, which for an ISO is normally the strike price, counts every ISO from the same employer, and takes grants in the order they were made.

A round-number illustration: 300,000 options at a $2 strike, vesting 25% a year. Each year 75,000 options first become exercisable, worth $150,000 at the grant-date price. The first $100,000 (50,000 options) can be ISOs; the other 25,000 options each year are NSOs, even if the grant notice calls the whole award an ISO. A grant that vests all at once, or a plan that lets you exercise before vesting, runs the entire award through the test in a single year. Most plan administrators split the award in their records; ask for the split before you exercise, because the two pieces are taxed differently.

Strike price, 409A value and the spread

The strike price is fixed at grant; the spread is the gap between the current value and that price, and it is the number the tax system cares about. For an ISO the strike must be at least the fair market value at grant (26 U.S.C. §422(b)(4)), and for a holder of more than 10% of the voting stock it must be at least 110% of that value with a term of no more than five years (26 U.S.C. §422(c)(5)). Private companies set fair market value through a section 409A valuation; an independent appraisal dated within 12 months of the grant is presumed reasonable (Treas. Reg. §1.409A-1(b)(5)(iv)(B)). That is why the strike on a new grant usually equals the latest 409A price.

The 409A value also sets the spread when you exercise. If the strike is $2 and the current 409A value is $12, the spread is $10 a share: wages for an NSO, an AMT adjustment for an ISO. As a company raises money at higher valuations the 409A price tends to rise, and the tax cost of exercising the same options grows with it. A tender-offer or IPO price above the 409A value does not change the spread until the 409A is updated, which is why the timing of an exercise relative to a new valuation matters.

What happens to your options when you leave?

Unvested options are usually forfeited, and vested options usually have to be exercised within a window set by the plan, commonly 90 days, or they expire. The tax code adds its own deadline: for an option to be taxed as an ISO, you must have been an employee at all times from grant until three months before exercise (26 U.S.C. §422(a)(2)). A plan that allows a longer window does not change that rule; an ISO exercised more than three months after employment ends is taxed as an NSO. Special rules apply for disability and death, and the plan document controls the window itself.

The window forces a decision: pay the strike price and any tax now, for illiquid shares, or let the options go. Ask for the current 409A value and the last day of your window on the day you give notice.

Early exercise, in brief

Some plans allow exercising options before they vest, taking restricted shares that the company can buy back if you leave. If you do, an election under section 83(b), filed within 30 days of the exercise on IRS Form 15620, fixes the taxable spread at that date rather than at vesting (26 U.S.C. §83(b)(2)) (IRS Form 15620); the rest of that decision belongs to a separate article. Without the election, the AMT adjustment on an early-exercised ISO is measured when the shares vest, when the spread may be larger (Instructions for Form 6251, line 2i).

An illustrative comparison: the same grant as an ISO and as an NSO

The figures below are hypothetical and rounded. An employee holds 10,000 options with a $2 strike, granted three years ago. The 409A value is $12 at exercise. The shares are later sold at $30. Federal figures are for 2026; state tax is left out, and so is the AMT arithmetic, which the companion article covers.

Hypothetical. 10,000 options, $2 strike, $12 fair market value at exercise, $30 sale price. 2026 federal rules; sources: 26 U.S.C. §§421, 422, 56(b)(3); IRS Publication 525; IRS Publication 15 (2026). Illustrative only, as of September 2026.

Event	NSO	ISO, qualifying sale (more than 2 years from grant and 1 year from exercise)	ISO, disqualifying sale (sold in the exercise year)
Grant	No tax	No tax	No tax
Exercise cost	$20,000	$20,000	$20,000
Spread at exercise	$100,000	$100,000	$100,000
Regular taxable income at exercise	$100,000 of wages on Form W-2; 22% federal withholding ($22,000) plus Social Security and Medicare	$0	$0
AMT adjustment at exercise	None	$100,000, reported on Form 3921; may or may not produce AMT	None, because the shares are sold in the same year
Basis after exercise	$12 per share	$2 per share for regular tax; $12 for AMT	$2 per share
Sale proceeds	$300,000	$300,000	$300,000
Ordinary income at sale	$0	$0	$100,000, reported by the employer as wages; no withholding required
Capital gain at sale	$180,000 long-term	$280,000 long-term (AMT gain $180,000; possible AMT credit)	$180,000 short-term
Income taxed at ordinary rates, in total	$100,000	$0	$280,000 ($100,000 of wages plus a $180,000 short-term gain)

The middle column is the ISO’s advantage: $280,000 of gain at long-term rates, paid for with AMT exposure in the exercise year and two holding-period clocks. The right-hand column, a quick sale after a tender offer or IPO, lands close to an NSO: no AMT, no withholding, and a short-term gain at ordinary rates.

The California layer

California follows the federal treatment of ISOs and NSOs, adds its own alternative minimum tax, and keeps taxing option income earned there after you move (FTB Publication 1004). Three points matter for anyone who worked in the state:

• California AMT. The state has its own AMT at a 7% rate on alternative minimum taxable income above an exemption (Cal. Rev. & Tax. Code §17062), and the ISO spread at exercise is an adjustment on California Schedule P just as it is on federal Form 6251 (FTB Publication 1004, Alternative Minimum Tax).
• NSOs after a move. California taxes the wage income from an NSO exercise to the extent the work between the grant date and the exercise date was performed in California, measured by workdays (FTB Publication 1004, Nonstatutory Stock Options). Move to Texas after four years in California and exercise a year later, and roughly four-fifths of the spread remains California wages, reported on a nonresident return.
• ISOs after a move. A qualifying disposition by a nonresident is not taxed by California; a disqualifying disposition’s wage portion is sourced from grant to exercise like an NSO, and the California AMT adjustment applies to the California-sourced share of the spread (FTB Publication 1004, Incentive Stock Options).

Texas levies no personal income tax (Tex. Const. art. 8, §24-a), so the state layer for a Texas resident is whatever California still claims. Keep the grant dates, the move date and a workday count; the arithmetic depends on them.

How we approach stock options in a plan

We start with an inventory, not a decision: every grant, its type, its strike, the ISO and NSO split, the vesting and expiration dates, and the current 409A value. From that list the spread on each grant, and the cash and tax cost of exercising it, can be laid out under this year’s brackets and the AMT. The exercise question then sits inside the whole household: how much of the family’s net worth the company already represents, what cash the strike price and the tax require, and whether a coming liquidity event changes the holding-period math. That is the core of our work on equity compensation and concentrated stock and our planning for executives and employees with equity pay. The tax side runs through our tax planning process with the household’s CPA, and a sale after an IPO connects to planning capital gains after a liquidity event.

Questions worth answering before you exercise

• Which of my options are ISOs and which are NSOs after the $100,000 test, according to the plan administrator’s records?
• What is the current 409A value, when was it set, and what is the spread on each grant today?
• What will the exercise cost in tax: the gap between withholding and my real bracket for an NSO, the AMT adjustment for an ISO?
• When do my options expire, and what is my exercise window if I leave?
• Can I sell these shares, and if not, when? Does a lockup or a company trading policy apply?
• If I worked in California, what share of the spread is still California-sourced?

What this does not mean

Nothing here is a recommendation to exercise, hold or sell any option or share, or a view on any company’s prospects. The comparison table describes tax mechanics under stated assumptions; which path suits a given person depends on cash, concentration, the company’s future and facts we have not seen. Tax figures reflect 2026 federal law and California rules as published; both change. Confirm your own numbers with a CPA or tax counsel before acting.

Frequently asked questions

Do I pay tax when stock options are granted?

Generally no, for either type. A private-company option has no readily ascertainable market value, so an NSO is not taxed at grant, and an ISO is never taxed at grant. Tax arrives at exercise for an NSO, and at sale (with a possible AMT adjustment at exercise) for an ISO.

What is the difference between a qualifying and a disqualifying disposition?

A qualifying disposition is a sale of ISO shares more than two years after the grant date and more than one year after the exercise date; the whole gain is long-term capital gain. A sale that misses either date is disqualifying: the spread on the exercise date becomes ordinary income in the year of the sale, and the rest is capital gain.

Why does my grant say ISO but the plan administrator shows some NSOs?

Because of the $100,000 limit in section 422(d). Only $100,000 of options, valued at the grant-date price, can first become exercisable in a calendar year as ISOs. Options above that line are treated as NSOs no matter what the grant notice calls them, and administrators track the split.

How long do I have to exercise after leaving a job?

The plan sets the window, commonly 90 days after employment ends. Separately, the tax code treats an option exercised more than three months after employment ends as an NSO, even if the plan allows a longer window. Unvested options are usually forfeited at departure.

Do ISOs avoid tax at exercise?

They avoid regular income tax at exercise. The spread is still an adjustment for the alternative minimum tax in the exercise year unless the shares are sold in the same year, and a large enough spread produces an AMT bill. Whether it does depends on your income, deductions and filing status.

Does California tax my options after I move to Texas?

Partly. For an NSO, California taxes the share of the spread earned by California workdays between grant and exercise. For an ISO sold in a qualifying disposition while you are a nonresident, California does not tax the gain; a disqualifying disposition’s wage portion is sourced the same way as an NSO. Texas has no personal income tax.

Sources and further reading

• 26 U.S.C. 422, incentive stock options: holding periods, employment requirement, option price, the $100,000 limitation
• 26 U.S.C. 421, general rules for statutory options and disqualifying dispositions
• 26 U.S.C. 56(b)(3), treatment of incentive stock options under the alternative minimum tax
• 26 U.S.C. 83, property transferred in connection with services; the 30-day 83(b) election
• 26 U.S.C. 1411, net investment income tax
• IRS Tax Topic 427, Stock Options
• IRS Publication 525, Taxable and Nontaxable Income, Stock Options
• IRS Publication 15 (2026), section 7, supplemental wages
• IRS, About Form 3921, Exercise of an Incentive Stock Option Under Section 422(b)
• IRS Form 15620, Section 83(b) Election
• IRS Instructions for Form 6251, line 2i, exercise of incentive stock options
• IRS, tax inflation adjustments for tax year 2026 (Rev. Proc. 2025-32)
• Rev. Proc. 2025-32, 2026 tax rate tables and capital gains thresholds
• Treas. Reg. 1.409A-1(b)(5)(iv)(B), valuation of stock not readily tradable on an established securities market
• California Franchise Tax Board, Publication 1004, Equity-Based Compensation Guidelines
• California Revenue and Taxation Code section 17062, alternative minimum tax
• Texas Constitution, Article 8, Section 24-a

Next steps

• IPO lockup expiration: what employees can do before release →
• Equity compensation and concentrated stock →
• Planning for executives and employees with equity pay →

Keep reading

Equity Compensation · 12 min readExercising ISOs Before an IPO: AMT in 2026Equity Compensation · 12 min readThe 83(b) Election: The 30-Day Deadline and When to FileEquity Compensation · 12 min readQSBS and California: The Exclusion California Doesn't Follow

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The views and opinions expressed here are those of The Financial Sciences Company as of the publish date and are provided for informational and educational purposes only. They are not personalized investment, tax, or legal advice. The Financial Sciences Company, LLC is a registered investment adviser. Registration does not imply a certain level of skill or training. Additional information is available in our Form ADV at adviserinfo.sec.gov.

General educational information, current as of 2026. Figures and rules change. For guidance specific to your situation, speak with a qualified professional.