ISO vs NSO: When Does the Employee Pay Tax?
Build a timeline: grant, exercise, sale. Then identify whether the option is an ISO or nonqualified option.
Nonqualified stock options
Under common fact patterns, exercise can create ordinary compensation income based on the spread, and a later sale can create capital gain or loss based on basis and holding period.
Incentive stock options
A qualifying ISO can avoid immediate regular-tax compensation income at exercise, but alternative minimum tax can become relevant.
Qualifying disposition
If statutory holding periods are satisfied, a later ISO sale can receive favorable capital-gain treatment under applicable rules.
Disqualifying disposition
Selling too soon can change the character and cause part of the gain to become compensation income.
Employer consequences
Employer deduction consequences can differ depending on whether qualifying ISO treatment is maintained or compensation income is recognized.
The takeaway
NSO often creates compensation at exercise. ISO can defer regular-tax recognition, but AMT and holding periods matter.
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FAQ
Can ISO exercise trigger AMT?
Yes.
Does NSO exercise commonly create ordinary compensation income?
Yes under typical fact patterns.
Does holding period matter for ISO treatment?
Yes.