An incentive stock option (ISO) is a stock option that meets the requirements of Internal Revenue Code Section 422 and can qualify for capital gains treatment on the entire gain, while a non-qualified stock option (NSO) does not qualify and is taxed as ordinary income on the spread at exercise.

Founders care because the ISO-versus-NSO choice decides how much of an employee’s stock gain the IRS takes as ordinary income and how much stays capital gain. Get the design wrong and you hand your team a worse after-tax result for the same equity, and equity design is one of the first things to settle when you start your company.

How an incentive stock option is taxed

An ISO can only go to employees. There is no tax at grant, and generally no regular income tax at exercise. If the holder meets the holding periods in Section 422(a)(1), the whole gain is long-term capital gains. That is a qualifying disposition.

The holding periods are strict. The holder must not sell within 2 years from the grant date and not within 1 year after the shares transfer at exercise. Section 422(a)(1) sets both. Miss either one and the sale becomes a disqualifying disposition, which is taxed more like an NSO.

Two more ISO rules bite in practice. Under Section 422(d), the total fair market value of stock that first becomes exercisable as ISOs in any one calendar year is capped at $100,000 per employee. Anything above that is treated as an NSO. And under Section 422(a)(2), the holder generally must exercise within 3 months after employment ends to keep ISO status.

The AMT trap on ISO exercise

ISOs are not tax-free at exercise. The bargain element, meaning fair market value minus strike price, is an adjustment for the alternative minimum tax under Section 56(b)(3). An employee can owe AMT in the exercise year even without selling a single share. This is the most common surprise we see. Model it before exercising.

How a non-qualified stock option differs

An NSO can go to employees, contractors, advisors, and directors. When the holder exercises, the spread between fair market value and strike price is ordinary compensation income under Section 83. For employees the company withholds and reports it on the W-2, and for non-employee holders such as contractors, advisors, and directors it is reported on Form 1099 with no withholding. Any later appreciation after exercise is capital gain.

Here is a concrete example. Suppose the strike price is $1 and fair market value at exercise is $5. On 10,000 shares, the $40,000 spread is ordinary income for an NSO in the exercise year. For an ISO held through both periods, that same $40,000 is instead part of a long-term capital gain, though it still counts for AMT at exercise.

Both option types must be priced at fair market value at grant, which is why startups get a 409A valuation. Both usually come out of the same option pool. And an early exercise of either can pair with an 83(b) election to start the clock sooner. For the full picture, see equity compensation.

This is general information, not tax advice.