Exercising Startup Stock Options: ISO vs NSO Tax and Forms

ISO vs NSO tax: what do you owe when you exercise?

With nonstatutory options (NSOs), you owe tax in the year you exercise, on the spread: the shares' value at exercise minus the price you pay. With incentive stock options (ISOs), exercise adds no regular income tax and no Social Security or Medicare tax, but the spread counts for the alternative minimum tax (AMT) unless you sell the shares in the same year (Publication 525; Topic 427). Your grant agreement says which kind you hold.

A case stops being simple when you exercise ISOs and keep the shares past year end (AMT), exercise after leaving the company, live or worked in more than one state between grant and exercise, or exercise before vesting. Gather the grant agreement, the exercise notice, the company's per-share value on the exercise date, Form 3921 or your W-2, and the broker statement for any sale.

Do you pay tax when stock options are granted or vest?

Generally no. A startup option almost never has a "readily determinable" value, because it is not traded and cannot be transferred, so an NSO is taxed when you exercise it rather than when it is granted or vests (Topic 427; 26 CFR 1.83-7). An ISO is never taxed at grant (Publication 525).

Vesting of the option itself is not a tax event. Vesting matters when you exercise before the shares vest: then NSO income can arise at vesting instead. See early exercise and the 83(b) election.

How are NSOs taxed when you exercise them?

The NSO spread is ordinary income in the exercise year. For an employee it is wages: the employer reports it on Form W-2 in boxes 1, 3 (up to the Social Security wage base) and 5, and in box 12 with code V (Publication 525; Publication 15-B).

That means Social Security tax of 6.2% on wages up to $184,500, Medicare tax of 1.45% with no cap, and Additional Medicare Tax of 0.9% withheld once your wages from that employer pass $200,000 (Publication 15).

A few private companies offer a section 83(i) election that lets an eligible employee defer the income for up to 5 years. It needs a qualifying company plan, must be filed within 30 days after the shares vest or become transferable, and makes an ISO an NSO (26 U.S.C. 83(i); 26 U.S.C. 422(b)).

An advisor or contractor gets NSOs, not ISOs; ISOs can only be granted to employees (26 U.S.C. 422(b)). The NSO rules apply to independent contractors too (26 CFR 1.83-7). The spread is then nonemployee compensation, generally reported on Form 1099-NEC, and amounts reportable there are generally subject to self-employment tax of 15.3% (1099-NEC instructions). Nothing is withheld, so the tax is paid through estimated payments.

How are ISOs taxed when you exercise them?

Exercising an ISO creates no regular taxable income and no W-2 wages (Publication 525). Social Security and Medicare tax never apply to an ISO exercise or to a later sale of the shares (26 U.S.C. 3121(a)(22)).

The AMT treats the exercise as if it were an NSO. The spread goes on Form 6251, line 2i, in the year the shares are vested (for vested options, the exercise year), and raises your AMT basis in the shares by the same amount. No adjustment is needed if you sell the shares in the same calendar year (Form 6251 instructions). Whether the adjustment produces AMT depends on your other income; see AMT on incentive stock options.

Why are some of my ISOs treated as NSOs?

An option labelled ISO is taxed as an NSO to the extent it misses a rule in section 422. The most common cause is the annual limit: options for stock worth more than $100,000, valued at grant, that become exercisable for the first time in one calendar year are NSOs for the excess (26 U.S.C. 422(d)). Options count in the order granted, and an option you can exercise only as it vests first becomes exercisable in the year it vests under its schedule (26 CFR 1.422-4).

Sources: 26 U.S.C. 422(a)–(c); Publication 525. Your company reports the ISO part on Form 3921 and the NSO part as wages, so check that the two together cover every share you exercised. For the window after leaving, see exercising options when you leave.

Qualifying sale or disqualifying disposition: how is the sale of ISO shares taxed?

A qualifying sale comes after both holding periods: more than 2 years from grant and more than 1 year from exercise. The whole gain over your exercise price is then capital gain (26 U.S.C. 422(a); Publication 525).

A sale, gift or other disposition before either date is a disqualifying disposition. In that year the spread at exercise becomes ordinary income, reported as wages, and only the gain above the value at exercise is capital gain. If you sell below the value at exercise, the ordinary income is limited to the actual gain, and a sale at a loss creates no ordinary income; this limit does not apply to a gift, a sale to a related person or a wash sale (26 U.S.C. 422(c)(2); 26 CFR 1.421-2(b); 26 CFR 1.422-1(b)(2)). The disqualifying income is not subject to Social Security or Medicare tax (Publication 15-B).

NSO shares have no special sale rule: gain or loss is measured from your basis, which is the price you paid plus the spread already taxed (Publication 525). For a sale in a tender offer or to an investor, see selling startup shares in a tender offer.

Which forms will I get: W-2, 1099-NEC, Form 3921 or 1099-B?

The form depends on the option type and who you are. Each form comes from the company or the broker, not the IRS, and you report from it on your own return.

Sources: Publication 525; Form 3921 instructions; 1099-NEC instructions. If your employer or former employer does not put disqualifying-disposition income on a W-2, you still report it as wages (Publication 525). A broker may not issue a 1099-B when vested option shares are sold the same day they are acquired (1099-B instructions).

Will tax be withheld, or do I need to make an estimated payment?

Only an employee's NSO exercise has withholding, and it is often too low. The employer may withhold income tax at a flat 22%, and must withhold 37% on supplemental wages above $1 million in the year (Publication 15). If your top bracket is higher than the flat rate, the rest is due with your return or earlier.

No withholding is required on an ISO exercise, on the AMT, on a disqualifying disposition (26 U.S.C. 421(b)) or on a contractor's NSO income. Under Publication 505, you generally must pay estimated tax if you expect to owe at least $1,000 after withholding and credits, and your withholding will be less than the smaller of 90% of this year's tax or 100% of last year's (110% if last year's adjusted gross income was over $150,000, or $75,000 if married filing separately). The installment dates are April 15, June 15, September 15 and January 15, 2027.

How do I report the sale so the same income isn't taxed twice?

Correct the basis on Form 8949. For options granted on or after January 1, 2014, the basis on Form 1099-B does not include the spread you already reported as income, so the 1099-B gain is too high by that amount (Publication 525). Fixing it is your job, not the broker's.

1. Enter the proceeds and the basis exactly as shown on the 1099-B in columns (d) and (e).
2. Enter code B in column (f).
3. In column (g), enter the adjustment as a negative number, in parentheses: the spread included in your income (from the W-2, 1099-NEC or your Form 3921 figures).
4. The result in column (h) is the true gain or loss (Form 8949 instructions).

These steps are for a 1099-B that says the basis was reported to the IRS. If it says the basis was not reported, enter the correct basis in column (e), code B in column (f) and zero in column (g).

Keep two bases for ISO shares held past the exercise year: the regular basis (your exercise price) and the AMT basis (exercise price plus the AMT adjustment). The sale is figured once with each (Publication 525).

When do the capital gain and QSBS clocks start for option shares?

Both start at exercise, not at grant. For an NSO without a readily determinable value, the holding period begins when you exercise; for ISO shares it begins the day after exercise (Publication 525). A gain is long-term when you hold the shares more than one year.

The QSBS exclusion looks at stock acquired at original issue, including stock received as pay for services (26 U.S.C. 1202(c)); holding an option does not count toward its holding period. Whether your shares qualify, and the holding tiers, are in QSBS for founders and early employees. Exercising early to start these clocks sooner is covered in early exercise.

Does my state tax stock options the same way?

Many states start from federal income, but each state sets its own rules. California follows the federal treatment of ISOs and NSOs, treats the NSO spread as wages subject to state withholding and disability insurance, and reports disqualifying-disposition income as state wages (FTB Publication 1004; EDD DE 231SK). California also applies its own AMT adjustment to ISOs.

If you moved between grant and exercise or sale, more than one state may tax part of the income; see moving to another state before selling startup shares.

Example

These examples are illustrative; figures are in US dollars. One employee holds 20,000 vested options at an exercise price of $1 when the shares are worth $6, a spread of $100,000.

NSO exercise

She exercises 20,000 NSOs, paying $20,000. The $100,000 spread appears on her W-2 in boxes 1, 3, 5 and 12 (code V), with Social Security and Medicare tax. Payroll withholds 22% income tax, $22,000. If her top bracket is higher, she owes the difference and checks whether an estimated payment is needed. Her basis in the shares is $120,000.

Same grant as ISOs, shares kept

She exercises 20,000 ISOs and keeps the shares past year end. Nothing goes on her W-2 and nothing is withheld. Form 3921 shows a $1 exercise price and a $6 value. She enters $100,000 on Form 6251, line 2i, which may create AMT. Her regular basis is $20,000 and her AMT basis is $120,000.

ISO shares sold too soon

She exercises the ISOs in February and sells all the shares in August of the same year at $8, receiving $160,000. This is a disqualifying disposition, and because she sold in the exercise year, no AMT adjustment applies. The $100,000 spread becomes W-2 wages, and the remaining $40,000 is short-term capital gain. The 1099-B shows a $20,000 basis; on Form 8949 she enters code B and a ($100,000) adjustment, so only $40,000 is taxed as gain. Nothing was withheld on the $100,000, so she checks her estimated payments.

Different for you?

• Your ISO spread is large and you will hold the shares past year end: see AMT on incentive stock options and get individual tax help before you exercise.
• You are leaving the company and have a deadline to exercise: see exercising options when you leave a startup.
• You exercised and the shares have fallen: see taxed on stock options that lost value.
• You want to exercise before vesting: see early exercise and the 83(b) election.
• You are selling in a tender offer or to an investor: see selling startup shares in a tender offer.
• You want to know if your shares are QSBS: see QSBS for founders and early employees.
• You run the company and are granting options: see granting stock options after a valuation.
• You live and work in Canada: see stock options for employees in Canada.
• You live in the US with options from a Canadian startup: see US resident with Canadian startup stock options.
• You moved between Canada and the US while holding awards: see stock awards and pay after a move and get cross-border tax help.
• Your forms do not match, or you missed income from an earlier exercise: get individual tax help.