How Employee Stock Options Are Taxed: ISOs, NQSOs, and AMT

Employee stock options are taxed at up to two moments: when you exercise them and when you sell the resulting shares. What you owe depends on which kind you hold. Non-Qualified Stock Options (NQSOs) are taxed as ordinary income on the spread the day you exercise, then as capital gains on any further appreciation when you sell. Incentive Stock Options (ISOs) can defer regular income tax entirely until sale and turn the full profit into a long-term capital gain, but the spread at exercise counts toward the Alternative Minimum Tax, and the capital gains treatment survives only if you meet strict holding periods. For 2026, ordinary rates on option income run up to 37%; long-term capital gains top out at 20%.

The Vocabulary That Drives Your Tax Bill

The exercise price (also called the strike price) is the fixed per-share amount you pay to buy stock under the option. Companies typically set it equal to the stock’s fair market value on the grant date. The vesting schedule controls when you can actually use your options; some plans vest all at once after a set period, others release portions over several years.

When you exercise, you pay the exercise price and take ownership of the shares. The spread (sometimes called the bargain element) is the difference between the stock’s fair market value at exercise and the price you paid. If your strike is $10 and the stock is worth $40 the day you exercise, the spread is $30 per share. That spread is the figure the tax rules work on, and the rules diverge sharply from here depending on the option type.

How Non-Qualified Stock Options Are Taxed

NQSOs follow the general rule for property received for services under Internal Revenue Code Section 83. Unvested options have no readily ascertainable value, so nothing is taxed at grant. The bill arrives at exercise.¹

Ordinary Income at Exercise

The full spread is taxed as ordinary income, the same as your salary. For 2026, the top federal rate of 37% applies to single filers with taxable income above $640,600 and married couples filing jointly above $768,700.² Your employer treats the spread as compensation: it appears in Box 1 of your W-2 and is subject to Social Security, Medicare, and income tax withholding, with the same amount shown separately in Box 12 under Code V.³

The Withholding Gap

This is where people get caught. Most employers withhold on the NQSO spread at the flat 22% supplemental wage rate, well below the rate anyone in the 32%, 35%, or 37% bracket actually owes. A large exercise can leave you tens of thousands short at filing time.

To avoid an underpayment penalty, you need to have paid in at least 90% of your current-year tax, or 100% of last year’s liability through withholding and estimated payments. If your prior-year adjusted gross income was over $150,000, that safe harbor rises to 110%. When a single exercise spikes your income, Form 2210 Schedule AI lets you annualize income across the four quarterly periods and may reduce the penalty.

Capital Gains When You Sell

The second taxable event is the sale. Your cost basis equals the exercise price plus the ordinary income already recognized at exercise. In the earlier example, a $10 strike plus $30 of recognized spread gives an adjusted basis of $40.¹

Any gain above that basis is a capital gain. Hold the shares more than a year after exercise and the profit is a long-term capital gain, taxed at 0%, 15%, or 20% depending on income. Sell within a year and the gain is short-term, taxed at your ordinary rate.⁴

Watch the Form 1099-B your brokerage sends. It often reports only the exercise price as your cost basis, ignoring the ordinary income you already paid tax on. If you don’t correct that on Form 8949, you’ll appear to have a larger capital gain than you actually do and pay tax on the same dollars twice. This is one of the most common and costly stock option tax errors.

How Incentive Stock Options Are Taxed

ISOs get more favorable treatment but under stricter rules. Follow them and the entire profit from strike to sale is taxed as long-term capital gain. Miss any of them and part of the gain reverts to ordinary income.⁵

No Regular Tax at Exercise

Exercise an ISO and you owe no regular federal income tax on the spread. Section 421(a) defers recognition as long as you meet the holding periods and remain employed, or exercise within three months of leaving.⁶ That deferral is the headline advantage of ISOs over NQSOs.

The Alternative Minimum Tax Catch

The deferral isn’t free. For AMT purposes, the spread at exercise is an adjustment: Section 56(b)(3) switches off the Section 421 exemption when you compute AMT.⁷ The entire spread gets added to income under AMT rules.

AMT is a parallel system. You run your regular tax, run the AMT calculation, and pay the higher of the two. For 2026 the AMT exemption is $90,100 for single filers and $140,200 for joint filers, phasing out at $500,000 and $1,000,000 respectively. AMT rates are 26% up to a threshold and 28% above it.² A large ISO exercise is one of the most reliable AMT triggers.

If AMT pushes your bill above your regular tax, the extra amount becomes a Minimum Tax Credit on Form 8801, carried forward indefinitely to offset regular tax in future years.⁸ You may not be able to use the credit until you sell the shares or your regular tax rises enough to exceed the AMT in a later year.

One bookkeeping headache: you track two different cost bases for the same stock. For regular tax, basis is the exercise price. For AMT, basis is the fair market value at exercise, because you already paid AMT on the spread. You’ll need both numbers at sale.

The $100,000 Annual Limit

Only so many ISOs can become exercisable for the first time in any calendar year. If the total fair market value of the underlying stock (measured at the grant date) exceeds $100,000, the excess options are automatically reclassified as NQSOs and taxed under NQSO rules.⁹ Grants are counted in the order they were made, which matters when vesting schedules from multiple grants overlap in the same year.

The Holding Periods That Set Your Rate

For ISOs, two clocks must both run out before sale. You need to hold the shares at least two years after the grant date and at least one year after the exercise date.⁵ Clear both and the full gain from strike to sale price is a long-term capital gain.

Sell before either deadline and you have a disqualifying disposition. The gain up to the exercise-date spread turns into ordinary income, erasing the ISO advantage on that slice. Appreciation above the exercise-date value stays a capital gain, short- or long-term depending on how long you held after exercise. The ordinary income portion lands on your W-2.

For NQSOs the picture is simpler because you already paid ordinary income tax at exercise. The long-term capital gains clock starts the day after exercise. Hold more than a year from that date for the preferential rate; sell sooner and the post-exercise gain is short-term.⁴

If You Leave the Company

Walking out the door starts a short clock on unexercised ISOs. You have three months from your last day of employment to exercise and preserve ISO treatment. After that, under most plans, the options either expire or convert to NQSOs and lose their tax-advantaged status.⁵ A disability extends the window to one year.

Some employers offer extended exercise windows past the standard period. The trade-off is tax: once the window stretches beyond three months from termination, ISOs automatically become NQSOs, and the spread at exercise becomes ordinary income subject to full income and employment taxes. NQSOs themselves don’t face the three-month constraint because they have no preferential status to lose, but your plan will still impose a contractual deadline.

Early Exercise and the 83(b) Election

Some startup plans let you exercise before shares vest. Those shares count as restricted property, and Section 83 would normally defer tax until vesting. A Section 83(b) election lets you choose to recognize the income immediately instead, before the stock appreciates. The election must be filed with the IRS within 30 days of exercise, and missing that window ends the option permanently.

The appeal: exercise early when the spread is small or zero, pay little or no tax now, and let future appreciation ride as a capital gain if you hold long enough. The risk: if the stock drops or the company fails, you’ve paid tax on income you never saw, and the tax isn’t refundable. The math tends to work for very early startup employees whose shares are worth almost nothing yet. For public-company options the stock already has substantial value, so early exercise rarely pays off.

Extra Taxes That Can Stack On Top

Two surtaxes aimed at higher earners can apply alongside the rules above.

The Additional Medicare Tax adds 0.9% once your wages pass $200,000 (single) or $250,000 (married filing jointly). NQSO ordinary income counts as wages for this purpose. Your employer only begins withholding the extra 0.9% after your wages with that employer cross $200,000, regardless of filing status, so you may still owe more at filing.¹⁰

The Net Investment Income Tax is a separate 3.8% on investment income, including capital gains, when modified adjusted gross income exceeds $200,000 (single) or $250,000 (married filing jointly). These thresholds are not indexed for inflation. NIIT doesn’t apply to wages, so NQSO ordinary income at exercise is outside its reach. Capital gains from selling shares obtained through either NQSOs or ISOs can trigger it.¹¹¹²

Getting the Reporting Right

The forms you receive won’t always reflect what you actually owe, which is where the biggest mistakes happen.

NQSO ordinary income flows through your W-2 in Box 1 and shows separately in Box 12 under Code V.³ No separate IRS form is filed for the exercise itself.

For ISOs, your company files Form 3921, reporting the grant date, exercise date, exercise price, and fair market value at exercise. You use that information to figure the AMT preference item on Form 6251.¹³¹⁴

When you sell, Form 1099-B reports proceeds and a cost basis. For NQSO shares the brokerage often reports only the exercise price, leaving out the ordinary income already taxed. Check the supplemental information statement for the adjusted basis and enter it in column (e) of Form 8949, or enter the unadjusted basis and make the correction in column (g). Skip this and you’ll be taxed twice on the same money.

ISO sales that clear both holding periods go on Form 8949 and Schedule D as long-term capital gains. Disqualifying dispositions split: the ordinary income portion is handled by your employer on your W-2, and any remaining capital gain goes on Form 8949. If AMT hit you in an exercise year, Form 8801 is how you claim the Minimum Tax Credit in a later year when your regular tax exceeds your AMT.¹⁵

1
Office of the Law Revision Counsel. 26 U.S. Code 83 – Property Transferred in Connection With Performance of Services
2
Internal Revenue Service. IRS Releases Tax Inflation Adjustments for Tax Year 2026
3
Internal Revenue Service. 2026 General Instructions for Forms W-2 and W-3
4
Internal Revenue Service. Topic No. 409, Capital Gains and Losses
5
Office of the Law Revision Counsel. 26 U.S. Code 422 – Incentive Stock Options
6
Office of the Law Revision Counsel. 26 U.S. Code 421 – General Rules
7
Office of the Law Revision Counsel. 26 U.S. Code 56 – Adjustments in Computing Alternative Minimum Taxable Income
8
Internal Revenue Service. Instructions for Form 8801
9
Office of the Law Revision Counsel. 26 USC 422 – Incentive Stock Options
10
Internal Revenue Service. Questions and Answers for the Additional Medicare Tax
11
Internal Revenue Service. Questions and Answers on the Net Investment Income Tax
12
Internal Revenue Service. Net Investment Income Tax
13
Internal Revenue Service. Form 3921 – Exercise of an Incentive Stock Option Under Section 422(b)
14
Internal Revenue Service. Instructions for Form 6251
15
Internal Revenue Service. About Form 8801, Credit for Prior Year Minimum Tax – Individuals, Estates, and Trusts