How Stock Options Are Taxed: ISO, NSO, AMT, and 83(b) Rules

How stock options are taxed depends on which kind you hold. Non-qualified stock options (NSOs) generate ordinary income the day you exercise, based on the spread between your strike price and the stock’s market value. Incentive stock options (ISOs) skip regular income tax at exercise and can qualify the entire gain for long-term capital gains rates if you hold the shares long enough, but the same exercise can trigger the Alternative Minimum Tax. On the same dollar of gain, the gap between the best and worst outcomes can approach 20 percentage points.

Non-Qualified Stock Options: Tax at Exercise

NSOs are the more common grant type and the simpler one to tax. Companies can issue them to employees, consultants, board members, or anyone else providing services. The taxable event is exercise. The difference between your strike price and the stock’s fair market value that day is ordinary income. Exercise 1,000 options with a $10 strike when the stock trades at $50, and $40,000 lands on your return as compensation.

Employers report the spread on your W-2 (box 12, code V) if you’re an employee, or on a 1099-NEC if you’re a contractor.¹ Because the IRS treats the spread as wages, it also carries payroll tax: 6.2% Social Security on earnings up to the $184,500 wage base in 2026, plus 1.45% Medicare with no cap. Compensation above $200,000 in a year picks up an additional 0.9% Medicare tax.²

Your cost basis in the shares after exercise equals the market value on that date, since you already paid tax on the spread. Any further appreciation follows normal capital gains rules: short-term if you sell within a year of exercise, long-term after that.

Incentive Stock Options: Tax at Sale

ISOs are available only to employees. The statute defines an ISO as an option granted for reasons connected with employment, which rules out consultants, advisors, and non-employee board members.³ The tradeoff is a real tax benefit: no regular federal income tax when you exercise and hold. Nothing shows up as ordinary income on your return that year.

The tax outcome hinges on when you sell. Meet two holding-period tests and the entire gain from strike price to sale price qualifies for long-term capital gains rates:

Two years from the grant date (not the vesting date).
One year from the exercise date.

A sale that clears both thresholds is a qualifying disposition. Miss either one and you have a disqualifying disposition: the spread at exercise (or your actual gain if smaller) reclassifies as ordinary income, and only the excess above exercise-date value stays a capital gain.³ Selling too early wipes out the ISO advantage.

The AMT Trap on ISO Exercises

The “no tax at exercise” rule for ISOs applies only to the regular tax. Under Section 56(b)(3), the ISO spread gets added back when calculating Alternative Minimum Taxable Income.⁴ You may owe no regular tax on that spread, and still owe a large AMT bill on it.

The AMT runs as a parallel calculation. You compute tax both ways and pay whichever is higher. 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. The rate is 26% on alternative minimum taxable income up to $244,500 above the exemption, and 28% above that.⁵

The painful part: you haven’t sold anything. You exercised, you’re holding stock, and the IRS wants a check based on a paper gain. If the share price falls after exercise, the AMT still gets calculated on the exercise-date value. Private-company employees who exercise large ISO grants before an IPO, or during a price spike, get caught by this in every market cycle.

Estimated Payments in the Year of Exercise

Nothing gets withheld on an ISO exercise, so a big exercise in any quarter can leave you badly underwithheld overall. The IRS charges underpayment penalties unless you’ve paid at least the smaller of 90% of your current-year tax or 100% of last year’s tax (110% if your prior-year AGI was above $150,000).⁶ Plan on making quarterly estimated payments in any year you exercise a meaningful ISO grant.

The AMT Credit

AMT paid because of an ISO exercise generates a minimum tax credit that carries forward. In a later year when your regular tax exceeds your AMT, you can apply the credit until you’ve recovered the full amount.⁷ You claim it on Form 8801, and it doesn’t expire. That prevents genuine double taxation over the long run, but recovery can take years and the time value of the cash is gone.

Capital Gains Rates on the Eventual Sale

The whole point of holding-period planning is reaching long-term capital gains rates, which for 2026 are:

0% on taxable income up to $49,450 single ($98,900 joint).
15% from $49,451 to $545,500 single ($98,901 to $613,700 joint).
20% above $545,500 single ($613,700 joint).⁵

The top ordinary income rate in 2026 is 37%, so qualifying for long-term treatment matters.⁵ For NSO shares, the holding period starts the day after exercise: hold more than a year and further appreciation qualifies for long-term rates.

High earners owe an additional 3.8% Net Investment Income Tax on capital gains. It applies to the lesser of your net investment income or the amount your modified AGI exceeds $200,000 single ($250,000 joint).⁸ A large option sale that pushes you well past those thresholds means your effective top rate on long-term gains is 23.8%, not 20%.

Deadlines That Change the Tax Result

Section 83(b) for Early-Exercised NSOs

Some startups let you exercise before shares vest. Filing a Section 83(b) election within 30 days of the transfer lets you pay ordinary income tax on the spread now, at a presumably low valuation, and shifts all future appreciation into capital gains territory.⁹ Miss the 30-day window and there is no recovery. If the stock later drops or you forfeit unvested shares, there is no refund of the tax you paid.

The 90-Day Post-Termination Window for ISOs

Leave your employer and unexercised ISOs convert to NSOs three months after your last day. Any exercise after that window produces ordinary income on the full spread.³ The window extends to one year for a permanent disability. Many holders don’t discover the rule until it’s already run.

The $100,000 Annual ISO Vesting Limit

Only $100,000 worth of ISOs, measured at grant-date fair market value, can first become exercisable for you in any single calendar year. The excess is treated as NSOs. Options are counted in grant order, earlier grants first. An acceleration event, like a change-of-control provision that makes everything exercisable at once, can push you over the ceiling and bifurcate a single grant into an ISO portion and an NSO portion.¹⁰

Section 83(i) Deferral for Private-Company Employees

Employees at qualifying private companies can defer income from an option exercise for up to five years under Section 83(i), which addresses the classic private-company problem of owing tax on shares you can’t sell.¹¹ The election must be made within 30 days of the date your rights become transferable or vested, and the deferral ends on the earliest of the stock becoming publicly tradable, you becoming an excluded employee (CEO, CFO, 1% owner, top-four highest paid), the five-year mark, or revocation. The company must have a written plan granting options or RSUs to at least 80% of its employees on the same terms. Few companies qualify in practice.

State Income Tax

Federal treatment is only part of the bill. State income tax rates on option income range from 0% in no-tax states to as high as 13.3%. Most states tax option income at their regular income tax rates and don’t distinguish between capital gains and ordinary income; a few do. If you exercised in one state and sold after moving to another, both states may claim a piece, depending on their sourcing rules. Combined marginal rates on option income can approach or exceed 50% for high earners in the highest-tax states.

The Forms You’ll See

For ISO exercises, your employer files Form 3921 and sends you a copy showing the grant date, exercise date, strike price, and exercise-date fair market value.¹² For NSO exercises, the ordinary income appears on your W-2 (box 12, code V) or on a 1099-NEC.¹

Sales get reported on Form 8949 and flow to Schedule D.¹³ Watch cost basis carefully: brokers frequently report the wrong number on ISO shares because they don’t reflect the AMT adjustment or the ordinary income from a disqualifying disposition. You may need to correct the reported basis on your return.

If you exercised ISOs during the year, Form 6251 determines whether you owe AMT; the spread goes on line 2i.¹⁴ Keep grant agreements, exercise confirmations, and brokerage statements for at least three years after the return reporting the sale. If you’re carrying an AMT credit forward, keep the records until the credit is fully recovered.

1
Internal Revenue Service. Instructions for Forms 1099-MISC and 1099-NEC
2
Internal Revenue Service. Topic No 751, Social Security and Medicare Withholding Rates
3
Office of the Law Revision Counsel. 26 USC 422 – Incentive Stock Options
4
Office of the Law Revision Counsel. 26 USC 56 – Adjustments in Computing Alternative Minimum Taxable Income
5
Internal Revenue Service. IRS Releases Tax Inflation Adjustments for Tax Year 2026
6
Internal Revenue Service. 2026 Form 1040-ES, Estimated Tax for Individuals
7
Internal Revenue Service. Topic No 556, Alternative Minimum Tax
8
Internal Revenue Service. Topic No 559, Net Investment Income Tax
9
Internal Revenue Service. Form 15620, Section 83(b) Election
10
eCFR. 26 CFR 1.422-4 – $100,000 Limitation for Incentive Stock Options
11
Internal Revenue Service. Notice 2018-97, Guidance on the Application of Section 83(i)
12
Internal Revenue Service. Instructions for Forms 3921 and 3922
13
Internal Revenue Service. Instructions for Form 8949
14
Internal Revenue Service. Instructions for Form 6251