ISOs vs. NSOs: What founders and early employees need to know about stock options and taxes

Equity compensation plays a significant role in startup culture. Beyond attracting and retaining talent, it can serve as an important component of compensation when cash resources are limited. As a result, having a general understanding of the structural and tax considerations associated with stock options can be helpful. Whether you are granting options or receiving them, misunderstanding the rules may lead to missed opportunities or unplanned tax consequences.

Below, we provide an educational overview of Incentive Stock Options (ISOs) and Non-Qualified Stock Options (NSOs), including how they are typically issued, how they are generally taxed, and key considerations founders and early employees may wish to keep in mind.

Stock option foundational knowledge

Stock options give recipients the right to purchase company shares at a predetermined price (the strike price) sometime in the future. Recipients don't actually own the shares until the options vest and are exercised.

Stock options are typically structured around a vesting schedule, such as four years with a one-year cliff. This means no options vest until the employee has been at the company for a year, after which 25% vests. The rest vests monthly, quarterly or annually over the next three years.

It's not just employees who can get options. Advisers and founders can too. Startups often rely on stock options to attract and motivate talent as well as to preserve cash. Founders often receive their own grants, especially in early stages.

ISO vs. NSO: Key differences

There are two main types of stock options: ISOs and NSOs. Though the names might sound similar, there are sharp differences in how they're taxed and who qualifies.

Incentive Stock Options (ISOs) can only be granted to employees of the issuing company — not board members, contractors or advisers. When structured and exercised correctly, ISOs receive favorable tax treatment: no regular income tax at exercise and potentially only long-term capital gains tax at sale.

Non-Qualified Stock Options (NSOs) can generally be issued to a broader group of recipients, including non employees. However, this flexibility typically comes with different tax consequences. NSOs are generally taxed as ordinary income at the time of exercise on the difference between the strike price and the fair market value (FMV) of the shares.

Tax considerations for ISOs

ISOs can offer potential tax advantages, but those benefits generally apply only when certain holding requirements are satisfied. To qualify for long term capital gains treatment, shares generally must be held for at least two years from the grant date and one year from the date of exercise before being sold.

ISOs can also create exposure to the alternative minimum tax (AMT). For AMT purposes, the difference between the strike price and the fair market value (FMV) of the shares at exercise — often referred to as the "spread" — is generally included as income. As a result, tax liability may arise even if the shares are not sold, which can be particularly impactful if options are exercised near a liquidity event.

Here's a hypothetical scenario. Say you're an employee who was granted 100,000 ISOs with a $1 strike price and exercised when the FMV hit $5. That's a $400,000 spread, potentially subject to AMT, even if you haven't sold the shares.

Because the tax treatment of ISOs can be complex, founders and early employees are encouraged to monitor vesting schedules and valuation changes and to consult qualified tax professionals to understand how these rules may apply to their specific circumstances.

Tax considerations for NSOs

NSOs are generally taxed as ordinary income at the time of exercise, based on the difference between the strike price and the fair market value (FMV) of the shares. Any subsequent gain or loss upon sale of the shares may be treated as capital gain or loss, depending on the length of time the shares are held after exercise.

Illustrative example: if you're an engineer granted 100,000 NSOs with a strike price of $1 a share. Two years later, the FMV at exercise is $5. Given the difference between the $5 FMV and $1 strike price, that means $4 is typically treated as income ($4 x 100,000 shares = $400,000 taxable ordinary income). You may need to cover the resulting tax liability using personal funds or selling shares back to the company. Shares that are retained after exercise and held for more than one year may be eligible for long term capital gains treatment on any subsequent sale.

One potential strategy to manage taxes is early exercise, which involves exercising options before they vest, when the FMV is closer to the strike price. In such cases, individuals may choose to file an 83(b) election within 30 days of exercise.

Filing an 83(b) election may allow the holder to recognize income earlier at a lower valuation and start the capital gains holding period sooner. However, this approach carries risk. If the shares are later forfeited or decline in value, previously paid taxes generally cannot be recovered, aside from potential capital loss treatment.

Option planning considerations for founders

As a founder, you're likely wearing two hats when it comes to stock options: granting them and receiving them.

When issuing options:

• ISOs are commonly used for employees, as they may offer more favorable tax treatment when statutory requirements are met.
• NSOs are often used for non-employees, and for grants that exceed ISO limitations, including the $100,000 annual vesting cap.

When receiving options:

• Be mindful of timelines. Most options expire 10 years after they're granted or 90 days after you leave the company.
• Consider exercise timing. Exercising options when the company's valuation is lower may reduce potential tax exposure, depending on circumstances.
• Evaluate income considerations. The timing of an exercise relative to overall income in a given year may influence tax outcomes.
• Look into Qualified Small Business Stock (QSBS). If your company qualifies and you exercise options into stock that meets QSBS criteria, you may be eligible to exclude up to $15 million in gains (or 10× your investment, whichever is greater) from federal capital gains taxes — for stock acquired on or after July 4, 2025. The holding period begins when you exercise the options and acquire the shares, not when the options are granted, so early exercise can be beneficial.

Seek professional guidance as you navigate stock options

Stock options can be a valuable component of compensation, but they are also complex. Decisions around grant structure, exercise timing, and tax elections can have significant financial implications.

Founders and early employees are encouraged to work with experienced legal and tax professionals to understand their options and obligations. Citizens Private Bank Relationship Managers and Private Wealth Advisors work alongside founders and their professional advisers to help align equity planning with the evolving financial priorities of the business. Learn more.