ISO vs NSO: Understanding the key differences

When you set up an equity plan, you'll need to decide between two types of stock options: Incentive Stock Options (ISOs) and Non-Qualified Stock Options (NSOs). The choice affects who can receive equity, how it's taxed, and what compliance requirements apply.

ISOs offer a federal tax advantage but come with strict eligibility rules: employees only, holding period requirements, and exposure to Alternative Minimum Tax. NSOs are more flexible, available to anyone providing services, and taxed more straightforwardly at exercise.

This guide covers how the two types compare across eligibility, exercise mechanics, tax treatment, AMT, California state tax, and 409A compliance.

What are stock options?

Stock options give the holder the right (but not the obligation) to buy shares in a company at a fixed price (the strike price, also called the exercise price) at some point in the future.

The value comes from the spread: if the company grows and shares become worth more than the strike price, the option holder can buy at the lower price and potentially sell at the higher one.

There are two types of stock options available to US companies:

Incentive Stock Options (ISOs)

ISOs are defined under Section 422 of the Internal Revenue Code. They are available to employees only and offer preferential federal tax treatment: no ordinary income tax at exercise, and long-term capital gains rates at sale if holding period requirements are met. In exchange for that tax advantage, ISOs come with stricter rules around eligibility, grant limits, and exercise windows.

Learn more about Incentive Stock Options.

Non-Qualified Stock Options (NSOs)

NSOs are the more flexible option type. They can be granted to employees, contractors, advisors, and board members, with no restriction on grant size and simpler compliance requirements. The tradeoff: the spread at exercise is taxed as ordinary income, with no deferral benefit.

Learn more about Non-qualified Stock Options.

ISO vs NSO Comparison

ISO vs NSO: Who can receive them?

The most fundamental difference between ISOs and NSOs is eligibility.

ISOs can only be granted to current employees.

‍Contractors, advisors, board members, and consultants are not eligible, regardless of how closely they work with the company.

NSOs have no such restriction. They can go to anyone providing services.

Full-time employees, part-time employees, contractors, advisors, and board members—all eligible for an NSO.

"NSOs are by far the most flexible type of stock options. You can grant it to an employee and non-employee, like an independent contractor. An ISO can only be granted to an employee, so there's like one restriction. An NSO has a lot more flexibility for startups when cash might not always be available to pay your bills."
^{—Matt Secrist, Partner at Taft Law}

The practical rule: any grant to a non-employee must be an NSO. ISOs are only on the table when the recipient is on payroll.

There are additional ISO-specific constraints beyond eligibility:

• $100,000 annual limit. ISOs that become exercisable in a single calendar year are capped at $100,000 in value (based on FMV at grant date). Anything above that automatically converts to an NSO.
• Plan requirements. ISOs must be issued under a written plan approved by shareholders within 12 months before or after the plan is adopted.
• Entity type. ISOs are only available to C-corps and S-corps. NSOs can be issued by any entity.

"You don't see ISO too much in the startup world. The reason I say you don't see it that much is because it's a little more complicated. There's a lot more bells, there's a lot more regulation versus NSOs."
^{—Matt Secrist}

ISO vs NSO: How are they exercised?

Exercising stock options simply mean paying the strike price to convert your option into actual shares — the process, timing, and tax consequences vary depending on whether you hold ISOs or NSOs.

Both ISOs and NSOs follow a vesting schedule before they can be exercised. Vesting conditions are set out in the option agreement or offer letter and are typically time-based (for example, a one-year cliff with monthly vesting over four years) or milestone-based.

Once vested, options can be exercised. The holder pays the strike price to acquire shares. The timing and mechanics differ between ISO and NSO.

Exercising ISOs

Under IRS rules, ISOs must be exercised within 10 years of the grant date (7 years for shareholders holding more than 10% of the company). They must also be exercised within 90 days of leaving employment to retain ISO tax treatment. After that window, any unexercised ISOs either lapse or convert to NSOs, depending on the plan.

Exercising NSOs

NSOs do not have a fixed expiration date under federal tax law, though company plans typically impose one. Like ISOs, NSOs are subject to a post-termination exercise window on departure, usually 90 days, though companies can extend this window at their discretion.

Cashless exercise is available for NSOs in some cases. This means, rather than paying the strike price in cash, the holder sells a portion of shares at exercise to cover the cost. This requires company approval, so option holders should confirm with the plan administrator before assuming it's available.

ISO vs NSO: How are they taxed?

Tax treatment is where ISOs and NSOs diverge most significantly.

ISOs: The qualifying scenario

When an employee meets both holding period requirements (at least 2 years from grant date and at least 1 year from exercise date), ISOs receive preferential federal tax treatment:

At grant: No tax event.

At exercise: No ordinary income tax. The spread is not taxed as income (though it is an AMT adjustment — see below).

At sale: The full gain from strike price to sale price is taxed at long-term capital gains rates.

Example: holding period met

• Year 1: employee is granted an ISO to acquire 10 shares at a strike price of $10/share
• Year 3: employee exercises and acquires all 10 shares when the share price is $50/share
• Year 5: employee sells all 10 shares at $100/share

In this case:

• At exercise: no federal income tax event.
• At sale: the employee recognises a gain of $900 ($1,000 sale proceeds minus $100 original cost), taxed at long-term capital gains rates.
• The company receives no tax deduction on a qualifying disposition.

ISOs: disqualifying dispositions

If shares are sold before the holding periods are met, it becomes a disqualifying disposition. The spread at exercise is taxed as ordinary income, and any further gain is taxed as short or long-term capital gains depending on how long shares were held post-exercise.

Example: holding period not met

• Year 1: employee is granted an ISO to acquire 10 shares at a strike price of $10/share
• Year 2: employee exercises and acquires all 10 shares when the share price is $50/share
• Year 2: employee sells all 10 shares at $100/share in the same year

In this scenario:

• At exercise: no immediate federal tax event.
• At sale (same year): the employee recognises $400 in wage income (the spread: $500 FMV at exercise minus $100 cost), taxed at ordinary income rates.
• The employee also recognises a $500 gain ($1,000 sale proceeds minus $500 FMV at exercise), taxed at short-term capital gains rates. The company can claim a tax deduction for the $400 wage income portion.

Most employees trigger disqualifying dispositions inadvertently, selling shares at an IPO or acquisition before the holding periods are satisfied from the exercise date.

NSOs: tax treatment

NSOs are taxed at two points: exercise and sale.

At exercise: the spread (FMV at exercise minus strike price) is treated as ordinary income. For employees it appears on the W-2; for non-employees it appears on a 1099. Both are subject to regular income tax. Employees also owe payroll taxes on the spread.

At sale: any appreciation after exercise is treated as capital gains. If shares are held for more than a year after exercise, long-term capital gains rates apply. Under a year, short-term rates apply.

Example: NSO with long-term hold

• Year 1: a service provider is granted an NSO to acquire 10 shares at a strike price of $10/share
• Year 3: the service provider exercises and acquires all 10 shares when the share price is $50/share
• Year 5: the service provider sells all 10 shares at $100/share

In this example:

• At exercise: the service provider recognises $400 in income (the spread: $500 FMV minus $100 cost), subject to income and employment taxes. The company can deduct this $400.
• At sale: the service provider recognises a capital gain of $500 ($1,000 sale proceeds minus $500 FMV at exercise). Because more than one year passed between exercise and sale, the long-term capital gains rate applies.

One practical advantage of NSOs for the company: the tax deduction at exercise. ISOs on qualifying dispositions don't generate a deduction, so NSOs can provide a meaningful offset for companies with large option pools.

ISO vs NSO: AMT exposure

Alternative Minimum Tax is the ISO risk that catches most employees off guard.

AMT is a parallel tax system that runs alongside regular federal income tax. You calculate your liability under both systems and pay whichever is higher.

ISO exercises create an AMT preference item. The spread at exercise (FMV minus strike price) is added to AMT income even though it isn't taxed as ordinary income. If your total AMT income crosses the exemption threshold ($88,100 for single filers in 2026, $137,000 for married filing jointly), you may owe AMT in the year of exercise with no corresponding cash from a sale.

Example: an employee exercises 50,000 ISOs when the strike price is $1 and FMV is $5. The spread is $200,000. Nothing is owed under the regular system. Under AMT, that $200,000 is added to AMT income, potentially triggering a tax bill of tens of thousands of dollars on a gain that hasn't yet been realised.

NSOs have no AMT exposure. The spread is taxed as ordinary income at exercise, which is straightforward.

AMT planning strategies

• ‍Exercise early. When the spread is near zero (close to grant date or a fresh 409A), the AMT impact is minimal. Early-stage employees who exercise shortly after grant often face little to no AMT.
• ‍Spread exercises across years. AMT is calculated annually. Exercising in tranches across multiple tax years can keep exposure manageable.‍
• 83(b) elections. Exercising early-stage unvested options and filing an 83(b) election within 30 days locks in the FMV at a low number, starting both the capital gains clock and the AMT calculation from a minimal base.‍
• AMT credit. AMT paid in one year becomes a credit against regular tax in future years when regular tax exceeds AMT. This provides eventual relief, but requires cash upfront.

Employees with meaningful ISO grants should model their specific scenario with a CPA before exercising. The interaction between regular income, AMT exemption phaseouts, and state taxes makes this genuinely complex.

ISO vs NSO: California state tax

California does not conform to federal ISO preferential tax treatment. Under California law, the spread at ISO exercise is taxed as ordinary income at the employee's California marginal rate, regardless of whether federal holding periods are met.

A California resident exercising ISOs gets:

• Federal: no ordinary income tax at exercise (subject to AMT)
• California: ordinary income tax on the spread at exercise (up to 13.3% state marginal rate)

California also operates its own AMT system, though at lower rates than the federal AMT.

For California employees, the ISO tax advantage is materially reduced. The federal capital gains benefit at sale still applies if holding periods are met, but the state-level hit at exercise applies regardless.

This is worth factoring in when deciding whether to grant ISOs or NSOs to California-based team members, and worth communicating clearly to employees before they exercise.

ISO vs NSO: 409A requirements

Both ISOs and NSOs share one compliance requirement: the strike price must equal or exceed the 409A FMV at the time of grant.

Granting options below 409A FMV, even unintentionally, creates a Section 409A violation. The consequences fall on the option holder: the option becomes taxable when it vests, plus a 20% excise tax penalty and interest on top of ordinary income rates.

Safe harbor under Section 409A requires an independent appraisal from a qualified appraiser. That appraisal is valid for 12 months, or until a material event such as a new funding round.

What we see on Cake: companies sometimes delay getting a 409A Valuation after a funding round and continue granting under the old valuation. A new round is a material event that requires a 409A Valuation refresh. Grants made in the gap are a compliance risk.

ISO vs NSO: Post-termination exercise window

The post-termination exercise window (PTE) is one of the most consequential but least communicated parts of any equity plan.

For ISOs: IRS rules require exercise within 90 days of leaving employment to retain ISO tax treatment. After 90 days, any unexercised ISOs either lapse or convert to NSOs, losing the preferential tax treatment. One exception: if an employee leaves due to disability, some plans allow a 12-month extension. The plan terms govern, so employees should check their option agreement.

For NSOs: the post-termination window is set by the company plan. Ninety days is standard, but companies can extend it to 5 or even 10 years. Unlike ISOs, there is no federal rule that forces NSOs to lapse or convert within 90 days. Some founder-friendly companies have extended windows significantly, though this requires board approval and plan amendments.

For employees at early-stage companies with high strike prices or large spreads, the 90-day window creates a difficult choice: find the cash to exercise (and potentially pay significant taxes) within three months of leaving, or walk away from the options. This is worth discussing with team members before they resign, not after.

ISO vs NSO: How to choose?

The short rule: any grant to a non-employee (advisors, contractors, board members) must be an NSO. ISOs are only available when the recipient is on the payroll. Beyond that, here's how the decision plays out in practice.

Scenario 1: Granting to your first advisor

Your advisor is unpaid, working with your company 5-10 hours per month on fundraising strategy. They won't be on payroll.

Use NSOs. ISOs are not available for non-employees. Full stop.

Scenario 2: Early full-time engineering hire, pre-seed

You're granting options to your first full-time engineer before your first external round. The 409A FMV is close to the strike price, perhaps $0.01 or $0.10 per share.

ISOs are worth considering here. The AMT exposure is minimal because the spread at exercise is near zero. If the engineer exercises early with an 83(b) election, they can lock in a very low AMT basis and start the capital gains clock early. The ISO tax advantage is most valuable for early employees who exercise when the spread is small.

The caveat: if the engineer is based in California, they'll owe state income tax at exercise regardless. Run the numbers.

Scenario 3: Series A, granting to VP of Sales

You're granting 150,000 options to a senior hire. The 409A FMV is $3.50 per share; the raise was at a $35M post-money.

Consider a mix, with NSOs likely dominant. The $100K annual vesting cap on ISOs may convert a portion of the grant to NSOs anyway. The spread at exercise will be significant if the company grows, which increases AMT risk. For high earners already AMT-exposed from other income, the ISO benefit gets murkier.

Communicate clearly to the candidate what type of options they're receiving. A direct conversation on exercise mechanics and tax implications builds more trust than a clean offer letter.

Scenario 4: Non-US team member

ISOs are a US tax concept. For employees in the UK, Canada, Australia, or elsewhere, local tax rules govern and ISO treatment doesn't apply. Use NSOs for all non-US grants and work with local counsel to understand whether a country-specific plan (such as EMI options in the UK) is worth establishing.

Scenario 5: Contractor converting to full-time employee

A contractor on NSOs is coming on full-time. Can you convert their NSOs to ISOs?

Generally no, and it's usually not worth it. Converting NSOs to ISOs is treated as a new grant and could trigger Section 409A issues if not handled carefully. Leave the original NSOs as-is and grant new ISOs from the employee option pool going forward.

What we see on Cake

Most companies we work with issue NSOs as their primary option type, or a mix of ISOs for employees and NSOs for non-employee grants. The ISO-for-everyone approach sounds appealing in theory, but between the $100K cap, AMT exposure, and California's non-conformity, the real-world advantage is narrower than it appears.

The most important thing isn't picking one type over the other. It's communicating clearly to your team what they're receiving, what the tax implications are at each stage, and what they need to do (or talk to a CPA about) before they exercise.