If a startup or public tech company gives you equity, it’ll come as one of three forms: Incentive Stock Options (ISOs), Non-Qualified Stock Options (NSOs), or Restricted Stock Units (RSUs). The tax treatment is wildly different across the three, and choosing the wrong strategy can leave six-figure sums on the table.
This guide compares all three side by side.
At a glance
| ISO | NSO | RSU | |
|---|---|---|---|
| Who gets it | US employees only | Anyone (employees, contractors, advisors) | Anyone, but usually employees |
| Tax at grant | None | None | None |
| Tax at vest | None | None | Ordinary income on FMV |
| Tax at exercise | AMT preference (no regular tax) | Ordinary income on spread | N/A |
| Tax at sale (qualifying) | LTCG on full appreciation | LTCG on post-exercise gain | LTCG on post-vest gain |
| Tax at sale (disqualifying) | Ordinary income on spread + LTCG/STCG remainder | N/A | LTCG/STCG |
| Strike price | Fair market value at grant | FMV or above at grant | None (free shares at vest) |
| Best for | Early-stage startup employees | Contractors, late-stage employees | Public company employees |
ISO (Incentive Stock Option)
An ISO is an option to buy shares at a fixed strike price. ISOs are governed by IRC §422 with strict requirements:
- Granted only to W-2 employees of the granting company (not its parent or subsidiary unless qualifying chains).
- Strike price ≥ FMV on the grant date.
- $100,000 vesting limit per year (excess auto-converts to NSO).
- Must be exercised within 3 months of leaving the company (else converts to NSO).
Tax pattern:
- At grant: No tax.
- At vest: No tax.
- At exercise: No regular tax, but the spread (FMV at exercise minus strike) is an AMT preference item. This is the famous AMT trap, exercising deep-in-the-money ISOs in a single year can trigger a giant AMT bill on paper gains.
- At sale (qualifying): Long-term capital gains on the entire appreciation, IF:
- Held > 2 years from grant date, AND
- Held > 1 year from exercise date.
- At sale (disqualifying): If you sell within those windows, the spread at exercise becomes ordinary income; only post-exercise appreciation is LTCG/STCG.
ISOs are the most tax-favored equity comp, full LTCG treatment on a qualifying disposition, but the AMT can blow up large exercise events. Always model AMT before exercising. Use our ISO AMT Calculator.
NSO (Non-Qualified Stock Option)
An NSO is also an option to buy shares at a fixed strike, but without §422’s qualifying status:
- Can be granted to non-employees (advisors, contractors, board members).
- No $100K vesting limit.
- No 90-day post-termination exercise window.
Tax pattern:
- At grant: No tax (assuming strike = FMV at grant).
- At vest: No tax.
- At exercise: The spread (FMV at exercise minus strike) is ordinary income AND subject to FICA. Your employer adds this to your W-2 wages and withholds at supplemental rates.
- At sale: Capital gain (or loss) on (sale price − FMV at exercise). Holding period for LTCG starts on exercise date.
NSOs lose the LTCG-on-spread benefit of ISOs, but the math is simpler, no AMT trap. Many later-stage employees actually prefer NSOs because the predictability is worth more than the maybe-LTCG benefit. See our NSO Calculator.
RSU (Restricted Stock Unit)
An RSU is a promise of shares, not an option. There’s no strike price, no exercise. Shares simply appear in your brokerage account on the vest date.
Tax pattern:
- At grant: No tax.
- At vest: FMV of vested shares = ordinary W-2 wages. Federal + state + FICA all apply. Withheld at the 22% supplemental rate (often under-withholds, see our RSU article).
- At sale: Capital gain (or loss) on (sale price − vest-date FMV). Holding period for LTCG starts on vest date.
RSUs are dominant at public US tech companies (Google, Meta, Amazon, Apple, Microsoft, Netflix, etc.) because they’re operationally simple: no strike price means no underwater shares.
The decision framework
When you can choose
Some companies let early employees choose between ISOs and RSUs. Generally:
- Choose ISOs if you have low current income (e.g., joining as a founder/early engineer at a startup), you can afford to exercise early and start the LTCG clock, you’re confident in upside, and you can plan around AMT.
- Choose RSUs if the company is post-IPO or pre-IPO with a defined liquidity timeline, you don’t want to put up cash to exercise, and you want predictable tax treatment.
Most equity grants are NOT optional
At most public US companies, you get RSUs. Period. The “choice” is whether to file an 83(b) on early-exercise ISO/NSO grants if available.
The 83(b) election
If you have early-exercisable options (some startups offer this), you can file an 83(b) election within 30 days of exercising. This locks in the spread between strike and FMV at exercise, which is often $0 at startups where FMV ≈ strike, and treats all subsequent appreciation as long-term capital gain.
Use 83(b) when:
- You’re at a very early-stage startup (FMV ≈ strike).
- You can afford to put up the exercise cash.
- You believe in the upside.
Don’t use 83(b) when:
- FMV is much higher than strike (you’d owe immediate ordinary income tax on the spread).
- You’re not confident the company will reach a liquidity event (lose the exercise cash if it fails).
The election is filed via paper letter to the IRS, within 30 days of the option exercise date, no exceptions. See 83(b) Calculator for the math.
AMT and ISOs, the trap
Alternative Minimum Tax was created to ensure high-income taxpayers pay some federal tax. The ISO exercise spread is one of the largest AMT preference items.
Worked example: Early engineer at a startup that IPO’d at $50/share, strike $1, holding 100,000 ISO shares.
- Exercise spread: ($50 − $1) × 100,000 = $4.9M
- AMT-includible: $4.9M minus AMT exemption (2026: $87,000 single / $135,250 MFJ)
- AMT tax at 28% (above $239,100 in 2026): ~$1.3M owed
That’s $1.3M in AMT due in April on a paper gain. If the stock then drops 50% before you sell, you’re underwater and possibly broke.
The fix: exercise in tranches across multiple tax years. Or exercise immediately at grant (when FMV ≈ strike) and file 83(b).
Common mistakes
Exercising ISOs all in one year. Massive AMT exposure. Spread across years.
Selling RSU shares early as a “disqualifying disposition.” RSUs don’t have qualifying/disqualifying terminology, that’s an ISO concept. RSU sales are always treated as you’d expect: vest = ordinary income, sale = capital gain/loss from vest-date basis.
Forgetting the holding period restart on options. LTCG clock starts at exercise, not at grant. Holding an ISO for 2 years from grant doesn’t help if you exercised yesterday.
Filing 83(b) late. 30 days from exercise. No exceptions. Late filings are simply rejected.
Confusing ISOs with ISO-eligible. Many companies grant “ISOs” that exceed the $100K vesting limit. The excess automatically converts to NSO with ordinary-income tax treatment. Read your option grant agreement carefully.
Worked example: comparing all three on $1M of gross equity value
Assume a senior engineer in California with $300K base salary, $1M of equity vesting over 4 years, current marginal rate ~50% (federal + CA).
Scenario A: $1M RSUs vesting over 4 years
- Each year: $250K added to W-2 income.
- Tax per year: ~$125K (federal + CA + FICA additional Medicare).
- Plus capital gains on post-vest appreciation.
- Total tax over 4 years (vest only): ~$500K.
Scenario B: $1M NSO with strike = grant FMV, exercised at vest, sold at exercise
- Same outcome as RSU effectively, spread at exercise is ordinary income.
- Total tax: ~$500K.
Scenario C: $1M ISO with strike = grant FMV, exercised early at FMV ≈ strike, held 2+ years, sold qualifying
- Exercise: $0 ordinary income, possible small AMT impact.
- Sale: LTCG on full $1M appreciation at 20% + 3.8% NIIT + 13.3% CA = ~$370K.
- Total tax: ~$370K.
- ISO advantage: ~$130K, but only if 83(b) timing worked and exercise was affordable.
Other countries
Equity comp tax treatment varies enormously:
- United Kingdom, EMI (Enterprise Management Incentive) options have ISO-like favorable treatment for small companies. Unapproved options are taxed as employment income.
- Canada, Stock options have a 50% inclusion rate (similar to capital gains), making them more favorable than ordinary income.
- Australia, ESS (Employee Share Scheme) rules: deferred taxing point, often at vest.
- India, Perquisite tax at exercise (employer’s responsibility); LTCG at sale if held >24 months.
Country guides coming.
Primary sources
- IRS Pub. 525, Taxable and Nontaxable Income (equity comp p. 9-12)
- IRC §422, Incentive Stock Options
- IRC §83(b), Property received for services
- IRS Form 6251, Alternative Minimum Tax (where ISO preference items live)