Compensatory Stock Options: NSO vs. ISO, AMT, and Reporting

Taxes on compensatory stock options depend almost entirely on one classification: whether the grant is a non-qualified stock option (NSO) or an incentive stock option (ISO). NSOs generate ordinary wage income the moment you exercise, with federal, Social Security, and Medicare tax withheld on the spread. ISOs defer all regular income tax until you sell the shares, but the same exercise can trigger the alternative minimum tax (AMT), and the favorable treatment only survives if you hold the shares long enough. Everything else — reporting forms, basis adjustments, surtaxes, early-exercise elections — flows from that first split.

Why the NSO vs. ISO Label Decides Your Tax Bill

The IRS recognizes two categories of compensatory stock options: statutory options (which include ISOs) and nonstatutory options (NSOs).¹ NSOs are the default. Any option that doesn’t meet the statutory requirements for ISO treatment is taxed as an NSO, and NSOs can go to employees, board members, or independent contractors.

ISOs must satisfy Section 422 of the Internal Revenue Code. The company’s stock option plan must be approved by shareholders, and the options can only go to employees of the company or its parent or subsidiary corporations. There is also a dollar cap: to the extent ISO grants become exercisable for the first time in any calendar year with an aggregate fair market value exceeding $100,000 (measured at the time of grant), the excess is automatically reclassified as NSOs.² When grants straddle that line, the oldest options keep ISO status first.

Your grant paperwork should say which type you have. If it doesn’t, assume NSO.

How NSOs Are Taxed

Nothing happens on the grant date, assuming the option has no readily ascertainable market value (true for virtually all compensatory grants). Vesting also triggers no tax on its own. The taxable event is exercise.³

When you exercise, the spread — the gap between the stock’s market value that day and the strike price you paid — is taxed as ordinary income in that year. It’s included in your gross income just like wages.⁴ Your employer treats the spread as supplemental wages and withholds federal income tax on it.⁵ The standard supplemental withholding rate is 22%, rising to 37% for supplemental wages above $1 million in a calendar year. If your actual marginal rate is higher than 22%, the shortfall is yours to cover in April.

Social Security and Medicare on the Spread

Because the spread counts as wages, it’s subject to Social Security tax (6.2%) up to the annual wage base of $184,500 in 2026, and Medicare tax (1.45%) with no cap.⁶ If your total wages for the year exceed $200,000 single or $250,000 married filing jointly, you also owe the 0.9% Additional Medicare Tax on the excess.⁷ A single large exercise can push you over that line, and employer withholding won’t fully account for it: your employer withholds the surtax only on wages it pays you above $200,000, regardless of filing status.

Basis and the Sale That Follows

Your tax basis in the shares equals the strike price plus the spread already taxed as ordinary income. Strike price of $10, market value of $30 at exercise: you recognize $20 per share as ordinary income, and your basis is $30. Future gain or loss runs from that $30 figure.

The capital gains holding period starts the day after exercise. Sell within a year and any gain is short-term, taxed at ordinary income rates. Hold more than a year and it qualifies as long-term capital gain, taxed at 0%, 15%, or 20% depending on income.⁸

Many employees use a cashless exercise: the broker exercises and sells simultaneously, delivering net proceeds after the strike price and withholding. Tax treatment of the spread is identical. There’s just no holding period, so no separate capital gain or loss unless intraday movement puts the sale price above or below the exercise-date value.

How ISOs Are Taxed

ISOs offer a real tax advantage: no regular income tax at exercise. When you exercise an ISO and hold the shares, the spread is not included in your regular taxable income, and your employer withholds no income or employment taxes on it.⁹ The tradeoffs are two: strict holding periods to preserve that treatment, and potential AMT in the exercise year.

Qualifying Dispositions

To get the full ISO benefit, you must hold the shares more than two years after the grant date and more than one year after the exercise date.² Meet both and the entire profit from sale (sale price minus strike price) is taxed as long-term capital gain. No portion becomes ordinary income, and the employer gets no corresponding deduction.⁹

Disqualifying Dispositions

Sell before either holding period is satisfied and the sale is a disqualifying disposition. The spread at exercise (market value on the exercise date minus strike price) is reclassified as ordinary income, much like an NSO.⁹ Any gain above that amount is capital gain, short-term or long-term depending on your post-exercise holding period.

There’s one silver lining if the stock dropped after exercise. If you sell for less than the exercise-date market value but more than the strike price, the ordinary income is limited to your actual profit on the sale rather than the full spread. Sell below the strike price and there’s no ordinary income at all, just a capital loss.

One detail catches people off guard: no income tax withholding is required on a disqualifying disposition.⁹ You owe the tax, but nothing comes out of the sale proceeds automatically. Without an estimated payment or set-aside, an underpayment penalty is waiting in April.

The AMT Problem With ISOs

Even though the ISO spread is excluded from regular taxable income, the tax code specifically provides that the favorable treatment of Section 421 does not apply for AMT purposes.¹⁰ The spread is added back to income when calculating AMT. The result can be a sizeable tax bill in a year you thought nothing extra was due.

The AMT runs a parallel calculation that includes certain income items and disallows certain deductions. You pay whichever is higher: your regular tax or the AMT. For 2026, the AMT exemption is $90,100 for single filers and $140,200 for married couples filing jointly, with phaseouts starting at $500,000 and $1,000,000 respectively.¹¹ A large single-year ISO exercise can easily blow through that exemption.

Calculate AMT liability on Form 6251.¹² Run the numbers before you exercise, not after. Splitting exercises across two calendar years sometimes keeps you under the exemption in both.

Getting the AMT Back

AMT paid because of an ISO exercise isn’t permanently gone. The ISO spread is a “deferral item,” meaning the timing difference between regular tax and AMT income eventually reverses.¹³ You carry the AMT forward as a minimum tax credit that offsets regular tax in later years when your regular tax exceeds your tentative AMT. Claim it on Form 8801, and keep filing the form each year until the credit is used up. Selling the ISO shares in a later year at a gain often creates enough of a gap to absorb most of the credit at once.

Two Different Cost Bases

When you exercise ISOs and hold the shares, you carry two cost basis figures. For regular tax, basis is the strike price. For AMT, basis is the strike price plus the spread already included in your AMT calculation. When you sell, these produce different gain amounts on the regular and AMT versions of your return. Getting this wrong is one of the most common ISO return errors; it can cause you to overpay or lose the minimum tax credit you were owed.

Early Exercise and the Section 83(b) Election

Some companies, particularly startups, let employees exercise options before vesting. The shares you receive remain subject to the company’s right to repurchase them if you leave early. Because the shares are restricted, Section 83 ordinarily delays the tax event until the restrictions lapse at vesting, at which point the spread between the then-current value and what you paid is ordinary income.

A Section 83(b) election overrides that default. You choose to recognize income immediately based on the stock’s value at the time of the early exercise. Exercise early when the stock is worth little (common in early-stage startups where strike price equals current value) and the spread may be zero, meaning no income to report. All future appreciation then qualifies for capital gains treatment once you meet the holding period.

The deadline is strict: file the election within 30 days of receiving the restricted shares. A copy also goes to your employer. There is no extension and no relief provision. Miss the window and the election is gone.

The risk cuts the other way too. If you file, pay tax on the current value, and then the stock becomes worthless or you forfeit the unvested shares by leaving, you don’t get a refund of the tax you paid. A capital loss may be available, but the election itself cannot be undone.

A Warning About Discounted Options and Section 409A

Section 409A of the Internal Revenue Code governs nonqualified deferred compensation, and stock options can fall under it if the strike price is below the stock’s fair market value on the grant date. These are discounted options. If an option is treated as deferred compensation under 409A and fails to comply, the spread is included in income at vesting, plus a 20% additional tax, plus interest.¹⁴ The penalties fall on the employee, not the employer.

This mostly surfaces at private companies, where fair market value isn’t set by a public market. ISOs meeting Section 422 are generally exempt from 409A, but NSOs priced below fair market value are fully exposed. If you’re joining a startup, confirm the company obtained an independent 409A valuation before pricing your options.

The Surtaxes That Quietly Add Up

Two federal surtaxes can apply on top of regular income and employment taxes.

The 3.8% Net Investment Income Tax applies to the lesser of your net investment income or the amount by which your modified adjusted gross income exceeds $200,000 single or $250,000 married filing jointly. Capital gains from selling option shares count as net investment income. An NSO exercise spread is wages, not investment income, so it isn’t directly subject to NIIT, but a large exercise can push your AGI past the threshold and expose your other investment income to the surtax.

The 0.9% Additional Medicare Tax applies to wages above $200,000 single or $250,000 married filing jointly.⁷ One large NSO exercise can push total wages well past those lines. Because employer withholding kicks in at $200,000 regardless of filing status, married filers at the $250,000 threshold may owe more at filing or have excess withholding to reclaim.

What to File and the Reporting Traps

Reporting correctly means reconciling several forms, and the numbers won’t always match your actual tax picture because each form captures only part of the transaction.

Form W-2 for NSO Exercises

The NSO spread appears on your W-2 in Box 1 (wages), Box 3 (Social Security wages, up to the wage base), and Box 5 (Medicare wages). Federal income tax withheld on the exercise shows up in Box 2.⁵ Because supplemental withholding is a flat 22% (37% above $1 million), high earners should expect to owe more at filing.

Form 3921 for ISO Exercises

Your employer files Form 3921 for each ISO exercise.¹⁵ It reports the grant date, exercise date, exercise price per share, fair market value per share on the exercise date, and the number of shares transferred.¹⁶ This is the data you need for the AMT adjustment on Form 6251. Keep it permanently. Years later, when you sell, you’ll need the grant date and exercise date to confirm whether you met the holding periods for a qualifying disposition.

Form 1099-B When You Sell

Your brokerage reports sale proceeds on Form 1099-B,¹⁷ and this is where most errors happen. The cost basis on the 1099-B frequently reflects only the strike price you paid, not the adjusted basis that includes the ordinary income already taxed at exercise. Report the 1099-B figures without correction and you’ll overstate the gain and pay tax twice on the spread.

Fix it on Form 8949 by entering the basis as reported on the 1099-B, then adjusting in Column G to reflect the income you already recognized. The corrected gain flows to Schedule D. This adjustment is your responsibility. The IRS matching system sees the 1099-B figures, and a lower reported gain without the right adjustment code triggers a notice.

Form 6251 and Form 8801 for AMT

If you exercised ISOs during the year, file Form 6251 to calculate whether AMT is due.¹² In later years, file Form 8801 to claim the minimum tax credit carried forward from prior AMT payments.¹³ Even when you don’t think you owe AMT, running the Form 6251 calculation is the only way to be sure.

1
Internal Revenue Service. Topic No. 427, Stock Options
2
Office of the Law Revision Counsel. 26 USC 422 – Incentive Stock Options
3
eCFR. 26 CFR 1.83-7 – Taxation of Nonqualified Stock Options
4
U.S. Government Publishing Office. 26 USC 83 – Property Transferred in Connection With Performance of Services
5
eCFR. 26 CFR 31.3402(g)-1 – Supplemental Wage Payments
6
Social Security Administration. What Is the Current Maximum Amount of Taxable Earnings for Social Security
7
Internal Revenue Service. Topic No. 560, Additional Medicare Tax
8
Internal Revenue Service. Topic No. 409, Capital Gains and Losses
9
Office of the Law Revision Counsel. 26 USC 421 – General Rules
10
Office of the Law Revision Counsel. 26 USC 56 – Adjustments in Computing Alternative Minimum Taxable Income
11
Internal Revenue Service. IRS Releases Tax Inflation Adjustments for Tax Year 2026
12
Internal Revenue Service. About Form 6251, Alternative Minimum Tax – Individuals
13
Internal Revenue Service. Instructions for Form 8801
14
Office of the Law Revision Counsel. 26 USC 409A – Inclusion in Gross Income of Deferred Compensation Under Nonqualified Deferred Compensation Plans
15
Internal Revenue Service. Instructions for Forms 3921 and 3922
16
Internal Revenue Service. Form 3921 – Exercise of an Incentive Stock Option Under Section 422(b)
17
Internal Revenue Service. About Form 1099-B, Proceeds From Broker and Barter Exchange Transactions