ISOs vs NSOs, the AMT trap, RSU taxation, 83(b) elections, and when to exercise — the complete guide to the most complex compensation most employees never fully understand.
Equity compensation comes in several forms, each with different tax treatment, vesting mechanics, and strategic implications. Understanding which type you have is the prerequisite for every other decision.
| Type | Who Gets It | Key Feature |
|---|---|---|
| ISO (Incentive Stock Options) | Employees only | Favorable AMT treatment; no ordinary income tax at exercise if rules followed |
| NSO (Non-Qualified Stock Options) | Employees, contractors, directors | Exercise triggers ordinary income tax on spread |
| RSU (Restricted Stock Units) | Most public company employees | Automatic delivery of shares at vesting; taxed as ordinary income |
| ESPP (Employee Stock Purchase Plan) | Public company employees | Discounted stock purchase; qualifying/disqualifying disposition rules |
| Phantom Stock / SAR | Often private companies | Cash equivalent to stock appreciation; taxed as ordinary income |
ISOs (Incentive Stock Options): When you exercise ISOs, you don't pay regular income tax at exercise. You only pay capital gains tax when you sell — and long-term capital gains rates apply if you hold the shares for at least 2 years from grant and 1 year from exercise. This is a significant tax advantage over NSOs.
NSOs (Non-Qualified Stock Options): When you exercise NSOs, the 'spread' (current stock price minus strike price) is taxed as ordinary income — immediately, at exercise, regardless of whether you sell the shares. Your company withholds taxes. This is the same tax treatment as receiving cash compensation, which is the worst-case scenario for stock options.
Some ISO plans allow early exercise (exercising before vesting using an 83(b) election). By exercising when the stock price equals or is near the strike price, you minimize the AMT calculation AND start the long-term capital gains clock earlier. Early exercise makes most sense for companies in early stages where the current 409A valuation is low.
The Alternative Minimum Tax (AMT) is the tax trap that catches many ISO holders by surprise. When you exercise ISOs, the spread is counted as an 'AMT preference item' — adding to your AMT income even though it's not regular taxable income. If your AMT income significantly exceeds your regular taxable income, you owe AMT.
If your company's stock price later drops below your exercise price, you've created an AMT liability on a gain that no longer exists. This happened to thousands of employees in the 2001 dot-com crash and 2008 recession — they exercised ISOs at peak valuations, owed AMT, and then watched the stock become worthless while still owing the tax. Consult a CPA before exercising significant ISO positions.
RSUs (Restricted Stock Units) have become the dominant form of equity compensation at large public companies because they're simpler and guaranteed to have value as long as the stock price is above zero. When RSUs vest, you automatically receive shares. The fair market value at vesting is taxed as ordinary income — it appears on your W-2. Your employer typically withholds shares to cover taxes automatically.
The RSU tax decision: most people sell some or all vested RSUs immediately to cover taxes and diversify out of employer stock. Holding concentrated employer stock is a concentration risk — your income and your investments both depend on the same company's performance.