ISOs vs. NSOs: What founders and early employees need to know about stock options and taxes

Equity compensation is a central part of startup culture. It's not just a way to attract and retain talent — it's often the main incentive when cash is tight. That's why understanding the technical and tax nuances of stock options is essential. Whether you're granting options to employees or receiving them yourself, getting it wrong can mean missed opportunities or unexpected tax bills.

Here we break down what you need to know about Incentive Stock Options (ISOs) and Non-Qualified Stock Options (NSOs) — how they're issued and taxed and how founders should navigate them.

Stock option foundational knowledge

Stock options give recipients the right to purchase company shares at a predetermined price (the strike price) sometime in the future. Recipients don't actually own the shares until the options vest and are exercised.

Stock options are typically structured around a vesting schedule, such as four years with a one-year cliff. This means no options vest until the employee has been at the company for a year, after which 25% vests. The rest vests monthly, quarterly or annually over the next three years.

It's not just employees who can get options. Advisers and founders can too. Startups rely on options to attract and motivate talent as well as to preserve cash. Founders often receive their own grants, especially in early stages.

ISO vs. NSO: Key differences

There are two main types of stock options: ISOs and NSOs. Though the names might sound similar, there are sharp differences in how they're taxed and who qualifies.

Incentive Stock Options (ISOs) can only be issued to employees — not board members, contractors or advisers. When structured and exercised correctly, ISOs receive favorable tax treatment: no regular income tax at exercise and potentially only long-term capital gains tax at sale.

Non-Qualified Stock Options (NSOs) can be issued to anyone, but that flexibility comes at a cost. NSOs are taxed as regular income at the time of exercise on the difference between the strike price and the fair market value (FMV) of the stock.

Tax implications of ISOs

ISOs offer significant tax benefits, but only if you meet specific holding requirements. To get long-term capital gains treatment, you must hold the shares for at least two years after the grant date and one year after exercising them before selling.

There's also a catch: the alternative minimum tax (AMT). The "spread" between the strike price and FMV at exercise counts as income for AMT purposes. This can trigger unexpected taxes, especially if exercised close to a liquidity event.

Here's an example. Say you're an employee who was granted 100,000 ISOs at $1 and exercised when the FMV hit $5. That's a $400,000 spread, potentially subject to AMT, even if you haven't sold the shares.

Founders and early employees should carefully track vesting, monitor FMV and assess their AMT exposure — especially before a big exit or IPO. Working with a tax adviser is crucial.

Tax implications of NSOs

NSOs are taxed as ordinary income upon exercise. You pay taxes on the difference between the strike price and FMV, and then again later as capital gains when you sell if held beyond one year from exercise.

For example, if you're an engineer granted 100,000 NSOs with a strike price of $1 a share. Two years later, the FMV at exercise is $5. Given the difference between the $5 FMV and $1 strike price, that means $4 is taxable as income ($4 x 100,000 shares = $400,000 taxable ordinary income). You will need to manage paying that tax through either current savings or selling shares back to the company to cover. Whatever shares you retain after exercise if held for one year can then be sold with standard long term capital gains treatment.

One way to lower the tax burden is by early exercise: That's buying the shares when the FMV is at or close to the strike price, minimizing the spread and thus the income tax. If you do this early and file an 83(b) election within 30 days, you can lock in the lower value and start the capital gains clock early. This means that if the company grows and share price rises, most of the future gain will be taxed at the lower capital gains rate instead of at a higher income tax rate.

The downside to the 83(b) election is if the company fails or your shares are forfeited, you cannot recover the taxes you already paid as part of the election. You're only allowed a capital loss for the amount you paid for the stock — not for the income you reported when you filed the election. While you can carry forward that capital loss for future gains, the initial tax outlay is lost. The strategy pays off only if the company succeeds and your shares appreciate.

Option planning for founders

As a founder, you're likely wearing two hats when it comes to stock options: granting them and receiving them.

When issuing options:

• Use ISOs for employees to offer better tax treatment
• Rely on NSOs for advisers, contractors or grants that exceed ISO limits (like the $100,000 annual vesting cap)

When receiving options:

• Track your timelines. Most options expire 10 years after they're granted or 90 days after you leave the company.
• Act early if you can. If the stock's value is low, consider early exercise and filing an 83(b) election to lock in lower taxes.
• Watch your timing. Exercise options in a year when your income is low to minimize tax impact.
• Look into Qualified Small Business Stock (QSBS). If your company qualifies and you exercise options into stock that meets QSBS criteria, you may be eligible to exclude up to $15 million in gains (or 10× your investment, whichever is greater) from federal capital gains taxes — for stock acquired on or after July 4, 2025. The holding period begins when you exercise the options and acquire the shares, not when the options are granted, so early exercise can be beneficial.

Seek expert guidance as you navigate stock options

Stock options are powerful tools, but poor timing or misunderstanding the rules can lead to big tax bills or lost opportunities.

Founders and early employees should seek out experienced legal and tax advisers to ensure they're issuing and exercising options in a compliant, tax-smart way. Citizens Private Bank can provide that guidance — helping founders make the most of their equity. Learn more.