What’s the difference between an ISO and an NSO?

Takeaway: The difference between an ISO and an NSO is all about taxes; ISOs offer potentially favorable tax treatment for employees but come with strict legal limits, while NSOs are simpler for the company and offer greater flexibility.

When your startup grants a stock option, it is not a one-size-fits-all instrument. The options granted under your stock plan will come in two primary "flavors": Incentive Stock Options (ISOs) and Non-qualified Stock Options (NSOs). From the company's perspective, they function similarly, but for the recipient, they have dramatically different tax consequences. Understanding this difference is essential for communicating your equity offer effectively and for managing your option plan in a compliant way.

Incentive Stock Options (ISOs): The Tax-Advantaged Choice

ISOs are the more tax-friendly option for the recipient, and as such, they are a powerful tool for attracting and retaining talent.

  • Who Can Receive Them: ISOs can only be granted to employees of the company. They cannot be granted to non-employee directors, consultants, or other advisors.

  • The Tax Treatment: The key benefit of an ISO is the potential for all of the gain to be taxed at the lower long-term capital gains rate.

    • At Exercise: Generally, when an employee exercises an ISO, there is no regular income tax due at that moment. (Note: This can trigger the Alternative Minimum Tax (AMT), a complex topic employees should discuss with a tax advisor).

    • At Sale: If the employee holds the stock for at least two years from the grant date and one year from the exercise date, the entire gain—from the initial exercise price to the final sale price—is taxed as a long-term capital gain.

  • The Limitations: This favorable tax treatment comes with strict rules that the company must follow:

    • The $100k Limit: For any single employee, only $100,000 worth of ISOs (valued based on the exercise price) can become exercisable for the first time in any given calendar year. Any amount over this $100,000 limit is automatically treated as an NSO for tax purposes. This limit can be particularly relevant for companies with large R&D payrolls.

    • Other Requirements: ISOs must be granted under a formal, stockholder-approved plan and generally must be exercised within 10 years of the grant date.

Non-qualified Stock Options (NSOs): The Flexible Standard

NSOs are the default, more flexible type of stock option.

  • Who Can Receive Them: NSOs can be granted to anyone: employees, directors, consultants, and advisors. They are the only type of option that can be granted to non-employees.

  • The Tax Treatment: The tax treatment for an NSO is less favorable but simpler.

    • At Exercise: The moment an individual exercises an NSO, the "spread"—the difference between the Fair Market Value (FMV) of the stock at the time of exercise and the exercise price—is taxed as ordinary income. This means the individual has a potentially large, immediate tax bill, and, if the individual is an employee, the company must handle the appropriate tax withholding.

    • At Sale: Any further appreciation in the stock's value from the date of exercise to the date of sale is taxed as a capital gain (either short-term or long-term, depending on how long the stock was held after exercise).

For most startups, the strategy is to grant ISOs to U.S. employees to the maximum extent possible under the $100k limit to give them the best possible tax outcome, and to use NSOs for all other grants.

Disclaimer: This post is for general informational purposes only and does not constitute legal, tax, or financial advice. Reading or relying on this content does not create an attorney–client relationship. Every startup’s situation is unique, and you should consult qualified legal or tax professionals before making decisions that may affect your business.