Deciding between Incentive Stock Options and Nonqualified Stock Options - Overview of ISO vs NSO Tax Treatment

Sep 19, 2026

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Stock options are employee compensation arrangements that grant the right to buy shares at a predetermined exercise price, typically subject to vesting based on time or performance. Employers must decide between incentive stock options (ISOs) and nonqualified stock options (NSOs) by assessing ISO qualification requirements under Internal Revenue Code section 422 and the practical business constraints they create. The document explains ISO eligibility conditions and contrasts tax consequences for employees and employers upon grant and upon exercise, including potential alternative minimum tax impacts and reporting duties.

LanguageEnglish

CategoryGeneral

FormatPDF

Pages7

Reading Time3 min

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Stock options and plan choice

ISO qualification requirements

How to decide between ISO and NSO

Tax treatment of ISOs

Employees

Employers

Deciding between incentive and nonqualified stock options Which stock option plan is right for your company? Prepared by: Anne Bushman, Partner, Washington National Tax, RSM US LLP[anne.bushman@rsmus.com](anne.bushman@rsmus.com), +1 202 370 8213 Michelle Borman, Senior Manager, Washington National Tax, RSM US LLP[michelle.borman@rsmus.com](michelle.borman@rsmus.com), +1 847 413 4690 Frank Tamai, Manager, Washington National Tax, RSM US LLP[frank.tamai@rsmus.com](frank.tamai@rsmus.com), +1 213 330 4791 November 2022 Stock options are a type of compensation device that provides the right to buy stock at an agreed-upon price (the exercise or strike price) . Typically, stock options are subject to vesting events based on time or performance requirements. Stock options are an effective compensation tool for two reasons. First, because they require an investment by the employee, they reinforce the employee’s commitment to the company. Second, because the options provide no benefit to the employee unless the company’s stock price goes up, they motivate the employee to increase the company’s value. Companies can choose between two types of stock option plans—incentive stock options (ISOs) and nonqualified stock options (NSOs) . Both types grant a holder the right to purchase stock over a future period at a given price, and make the holder a legal corporate owner (shareholder) upon exercise. However, there are considerable differences between the two, which employers must understand in order to make a fully informed choice. Structure of ISOs and NSOs To qualify for ISO treatment, stock options must meet all of the following requirements under Internal Revenue Code section 422: 1. The options must be granted to employees. 2. The options must be granted in accordance with a written plan that (a) is approved by a formal vote of shareholders within 12 months before or after the plan’s effective date,(b) includes the aggregate number of shares available to be granted, and (c) includes the employees or class of employees eligible to receive options. 3. The options must be granted within 10 years from the date the plan is adopted or the date the plan is approved by shareholders, whichever is earlier. 4. The exercise price must not be less than the fair market value (FMV) of the stock on the date of grant (but see No. 6 below) . 5. The term of the options must not exceed 10 years from the date of grant (but see No. 6 below) . 6. Options granted to a shareholder who owns 10% or more of the total combined voting stock of the company (or its parent or subsidiary) must have an exercise price of at least 110% of the FMV on the date of grant, and the term of the options must not exceed five years. 7. The options must not be transferable except upon death. 8. The options must be exercised while the employee is still employed or within three months of termination of employment (12 months if the termination is the result of death or disability) . 9. There is a $100,000 limit (measured on the grant date) on the value of stock underlying the options that can first be exercised by an employee in any given calendar year. In the case of multiple grants, this limitation is absorbed in the order the options were granted. An option that does not meet one or more of the above requirements, or exceeds the $100,000 limit, is automatically an NSO. There are no specific statutory requirements to qualify as an NSO (but see section 409A considerations below) . In evaluating which option to provide, the employer must first identify whether any of the ISO requirements are problematic from a business perspective. If so, NSOs would be the appropriate choice. In fact, most option grants are structured as NSOs for their added flexibility. If the company is amenable to the above ISO requirements, the next factor to consider is differences in tax treatment. Tax treatment of ISOs If stock options are designed to meet all of th

FAQs

What are the key differences between incentive stock options (ISOs) and nonqualified stock options (NSOs)?

ISOs must satisfy specific requirements under Internal Revenue Code section 422, while NSOs are used when ISO requirements are problematic or not met. Both grant the right to purchase stock at a future date and price, but tax outcomes differ, including employee AMT considerations for ISOs.

Which ISO requirements commonly prevent an option grant from qualifying as an ISO?

ISO qualification requires employee-only grants, a shareholder-approved written plan, grant timing rules, an exercise price meeting fair market value limits, term restrictions, transfer limits, and specific post-termination exercise windows. Violations of these items, or exceeding the $100,000 limitation on exercisable option value per year, cause automatic treatment as NSOs.

How are ISOs taxed for employees and employers when there is a qualifying disposition?

For employees, there is generally no income reported at grant, and no income at exercise other than potential AMT impact from the value spread. If shares are held long enough, gains or losses are treated as capital gain or loss. For employers, there is generally no income tax deduction at grant or exercise, and reporting obligations include providing an information statement and filing Form 3921 with the IRS.

Sep 19, 2026

Upload by Skyler