How Do Employee Stock Options Work: ISOs, NSOs, and AMT

Employee stock options work by giving you the right, but not the obligation, to buy a set number of your employer’s shares at a fixed price once you’ve earned that right through time on the job. The fixed price is locked in on the grant date, so if the stock climbs, you can buy in at the old price and capture the difference. What you’ll owe in tax depends on which of two types you hold, when you exercise, and how long you keep the shares afterward.

The Two Types: ISOs and NSOs

Federal tax law splits employee stock options into two categories, and the tax rules diverge sharply between them.

Incentive Stock Options (ISOs) are the tax-advantaged type. To qualify under IRC Section 422, the option price has to be at least the stock’s fair market value on the grant date, the option has to expire within ten years, and it can’t be transferred during your lifetime except by inheritance.¹ ISOs can only go to employees. Independent contractors, consultants, and non-employee board members are not eligible.²

Non-Qualified Stock Options (NSOs) are anything that doesn’t meet the ISO rules. Because they aren’t bound by those restrictions, companies can grant them to employees, contractors, consultants, and outside directors alike. NSOs are taxed under IRC Section 83, which governs compensation paid in property.³

Vesting: When You Can Actually Exercise

A grant doesn’t let you buy anything on day one. Almost every grant comes with a vesting schedule, and until an option vests, you have only a conditional right that disappears if you leave too soon.

Two schedules dominate:

Cliff vesting: nothing vests until a set date, often the one-year mark, when a chunk (commonly 25%) vests all at once.
Graded vesting: options vest in regular installments, such as 25% per year over four years.

Many companies combine the two, using a one-year cliff followed by monthly or quarterly graded vesting for the rest. Unvested options are typically forfeited the day you leave.

The $100,000 ISO Cap

There’s a ceiling on how much of your grant can qualify as ISOs. Federal law caps the total value of ISOs that can become exercisable for the first time in any single calendar year at $100,000, measured by the fair market value on the grant date, not the current price.¹ Anything above that threshold in a given year is automatically reclassified as NSOs and taxed accordingly.⁴ Earlier-granted options are counted against the limit first.

How Exercising Works

Exercising is the act of using your right to buy the shares at your strike price (also called the exercise price or grant price). Check your grant agreement and plan document, usually on your company’s equity platform, to confirm the strike price and how many vested shares you have available.

The cash you’ll need is the strike price times the number of shares. Exercise 1,000 vested options at a $10 strike price and it costs $10,000 to buy the shares. Most platforms tack on a small transaction fee, often a few dollars up to about $25 per exercise.

Three exercise methods are typical:

Cash exercise: you pay the full strike price yourself and receive the shares in your brokerage account.
Cashless exercise, or same-day sale: your broker sells shares immediately, uses the proceeds to cover the strike price and taxes, and deposits the rest as cash. No money required upfront.
Stock swap: if your plan allows it, you surrender shares you already own to pay the strike price, receiving new shares in return.

You start the process by submitting an exercise request on your company’s equity platform. Once the company processes it and payment clears, the shares land in your brokerage account.

How NSOs Are Taxed

Exercising an NSO triggers ordinary income tax right then. The taxable amount, called the spread, is the difference between the stock’s fair market value on the exercise date and your strike price.⁵ Exercise 1,000 shares at a $10 strike when the stock is at $30 and your spread is $20,000, taxed like regular wages.

Your employer withholds on the spread at exercise. For 2026, the federal supplemental wage withholding rate is 22% on the first $1 million and 37% above that.⁶ Social Security tax of 6.2% applies to the spread up to the 2026 wage base of $184,500, counting all your wages for the year.⁷ Medicare tax of 1.45% applies to the entire spread with no cap. The spread lands on your W-2, and any income tax not covered by withholding is due when you file. The top federal income tax rate for 2026 is 37%.⁸

If you hold the shares after exercising and later sell, any additional gain or loss from the exercise date forward is a capital gain or loss. Hold more than a year after exercise and it qualifies for long-term capital gains rates.

How ISOs Are Taxed

ISOs run on a different track. When you exercise, the spread is not treated as ordinary income for regular federal income tax. Nothing is withheld and nothing shows up on your W-2.⁵ Your employer does file Form 3921 with the IRS reporting the exercise, and you’ll receive a copy.⁹

The AMT Trap

The spread on an ISO exercise is an adjustment item for the Alternative Minimum Tax. You report it on Form 6251, and if that adjustment pushes your AMT liability above your regular tax, you owe the difference.⁵ For 2026, the AMT exemption is $90,100 for single filers and $140,200 for married couples filing jointly, with phase-outs starting at $500,000 and $1,000,000 respectively.⁸ A large ISO exercise can blow past those exemptions and produce a real AMT bill in a year when you haven’t sold a single share.

The Holding Periods

To get the best tax result, called a qualifying disposition, you have to hold the shares at least one year after exercise and at least two years after the original grant date. Meet both deadlines and your entire profit is taxed as long-term capital gain rather than ordinary income.¹

Sell before you clear either deadline and it’s a disqualifying disposition. The spread at exercise is reclassified as ordinary income, and any additional gain above the exercise-date fair market value is a capital gain, short-term or long-term depending on your post-exercise holding time.¹⁰

Getting AMT Back

AMT you paid because of an ISO exercise isn’t necessarily lost. It generates a minimum tax credit you can claim in later years when your regular tax exceeds your AMT, using IRS Form 8801.¹¹ Unused credit carries forward until fully recovered.

2026 Long-Term Capital Gains Rates

When you satisfy the ISO holding periods, or hold NSO shares more than a year after exercise, your gain gets long-term capital gains rates. For 2026, those rates are 0%, 15%, or 20% depending on your taxable income.¹² Compared with the 37% top ordinary rate, qualifying can save real money on a large exercise.⁸

The 3.8% Net Investment Income Tax

High earners owe an extra 3.8% Net Investment Income Tax on top of everything else. It applies to the lesser of your net investment income or the amount your modified adjusted gross income exceeds $200,000 (single) or $250,000 (married filing jointly). Those thresholds don’t adjust for inflation.¹³ Capital gains from option shares count as net investment income.¹⁴ A big sale can drag you over the line and add 3.8% to your effective rate. Many option holders forget about it. For those subject to it, the effective top rate on long-term capital gains reaches 23.8%.

The Section 83(b) Election for Early Exercise

If your company lets you early-exercise, meaning buy shares before they’ve vested, you can file a Section 83(b) election. This tells the IRS to tax the spread now, at today’s value, instead of waiting for each batch to vest.³ In an early-stage startup where the stock is barely worth anything, the current tax hit can be tiny. All future appreciation above the value at election is then taxed as capital gain when you eventually sell.

The deadline is unforgiving. You must file IRS Form 15620 within 30 days of the stock transfer. It cannot be extended, and a late filing cannot be corrected.¹⁵ The risk: if you leave before the shares vest and forfeit them, you don’t get back the tax you already paid.

Watch the Wash Sale Rule

If you sell option shares at a loss and exercise more options for the same company’s stock, or buy that stock on the open market, within 30 days before or after that sale, it’s a wash sale. You can’t deduct the loss on that year’s return.¹⁶ The disallowed loss isn’t gone forever; it’s added to the cost basis of the replacement shares, so you get the deduction later when you sell those. But it can wreck a plan that relied on the loss offsetting other gains this year.

What Happens When You Leave

Leaving your employer starts a clock on your unexercised vested options. For ISOs, federal tax law gives you three months from your last day to exercise and keep ISO treatment. Miss that window and those ISOs automatically convert to NSOs and are taxed as such. Disabled employees get a year.¹

For NSOs, the deadline comes from your company’s plan document. Post-termination exercise windows run anywhere from 30 days to 10 years, with many startups landing on 90 days. Regardless of what the plan says, no option survives past its original expiration, usually ten years from grant. Any unvested options are typically gone the day you walk out.

1
Office of the Law Revision Counsel. 26 USC 422 – Incentive Stock Options
2
eCFR. 26 CFR Part 1 – Certain Stock Options
3
Office of the Law Revision Counsel. 26 USC 83 – Property Transferred in Connection With Performance of Services
4
eCFR. 26 CFR 1.422-4 – $100,000 Limitation for Incentive Stock Options
5
Internal Revenue Service. Topic No. 427, Stock Options
6
Internal Revenue Service. Publication 15 (2026), Employers Tax Guide
7
Social Security Administration. Contribution and Benefit Base
8
Internal Revenue Service. Tax Inflation Adjustments for Tax Year 2026
9
Internal Revenue Service. About Form 3921, Exercise of an Incentive Stock Option Under Section 422(b)
10
Office of the Law Revision Counsel. 26 USC 421 – General Rules
11
Internal Revenue Service. Instructions for Form 8801
12
Internal Revenue Service. Revenue Procedure 2025-32, 2026 Adjusted Items
13
Office of the Law Revision Counsel. 26 USC 1411 – Imposition of Tax
14
Internal Revenue Service. Questions and Answers on the Net Investment Income Tax
15
Internal Revenue Service. Form 15620, Section 83(b) Election
16
Internal Revenue Service. Case Study 1 – Wash Sales