ISO vs. NSO

Incentive stock options (ISOs) can only be granted to employees (not contractors, advisors, or board members) and offer preferential tax treatment — no ordinary income tax at exercise, and potential long-term capital gains treatment on eventual sale if specific holding period requirements are met — but they're subject to a $100,000 annual vesting value limit and can trigger alternative minimum tax (AMT) at exercise.

Non-qualified stock options (NSOs) can be granted to anyone — employees, contractors, advisors, board members — with no dollar limit, but they're taxed as ordinary income on the spread between strike price and fair market value at the time of exercise, regardless of whether the holder actually sells the shares.

The ISO tax benefit has strict conditions. To get the favorable treatment on sale, the tax code says the shares can't be disposed of within two years from the grant date or within one year after the shares were transferred to the employee at exercise; a sale that breaks either rule is a 'disqualifying disposition,' and part of the gain is taxed as ordinary income.

ISOs also carry an alternative minimum tax trap. For AMT purposes, the usual ISO rule doesn't apply at exercise, so the spread between strike price and fair market value counts toward alternative minimum taxable income — an employee can owe real cash tax in the exercise year without selling a share, even if the stock later falls. Model AMT before exercising a large ISO block.

ISO status also depends on timing after you leave. The tax code requires an ISO to be exercised within three months after employment ends (one year in the case of disability) to keep ISO treatment, which is why many companies' default post-termination exercise window is three months. NSO windows are whatever the plan says.