The main difference between ISOs and NSOs is how they are taxed. Shares from an ISO can “qualify” for beneficial tax treatment depending on when you sell. Shares from an NSO exercise will be taxed at your regular income rates.
With an ISO, you will not be subject to tax at the time of exercise and no withholding or Social Security/Medicare tax applies. This is because your shares can be eligible for beneficial tax treatment, so you don’t know what types of taxes you will have until you sell the shares that result from the exercise.
When you sell your ISO shares from the exercise, your entire gain (or loss) over the exercise price will be treated as a capital gain (or loss) provided the shares are held for the required holding period. This is called a qualifying disposition.
To receive beneficial treatment, the shares must be held for:
- More than one year from the exercise date.
- More than two years from the grant date.
If shares are sold before these holding periods end, you will have what is called a disqualifying disposition and the shares will not receive beneficial tax treatment and will be taxed similarly to an NSO, but with no withholding or Social Security/Medicare tax.
It’s important to remember that alternative minimum tax, or AMT, may apply when you hold the ISO shares through the calendar year of exercise. AMT is an alternative method for calculating your taxes that is triggered by specific events, such as the exercise of an ISO.
ISO taxes can be complicated, so it is important that you consult a tax advisor regarding your personal tax situation.
In contrast, when you exercise an NSO, the difference between the fair market value at exercise and the grant price —also known as the “spread”— will be treated as ordinary compensation income. Your employer will generally be required to withhold taxes at the time of your exercise. When you sell the shares you received from the exercise, your subsequent gain or loss will be subject to tax as a capital gain (or loss).
For additional information, visit the Taxes and tax-filing page.
