ISO vs. NSO vs. RSU: How Employee Equity Awards Are Taxed

The IRS divides stock options into two categories. Options granted under an employee stock purchase plan or an ISO plan are statutory stock options. Options granted outside those plans are nonstatutory stock options.^[2] A restricted stock unit is a separate instrument: your employer promises to transfer shares once you meet a vesting condition, typically a period of service.

All three award types can create income at different moments. The IRS identifies three points when stock option income can arise: when you receive the option, when you exercise it, and when you dispose of the option or the shares acquired on exercise.^[1] For equity award holders who need help reporting these awards each year, our individual tax return preparation team handles ISO, NSO, and RSU tax filings.

The favorable treatment of an ISO begins at exercise. If your employer grants you a statutory stock option, you generally do not include any amount in your gross income when you receive or exercise the option.^[3] That means the spread between your grant price and the fair market value on the exercise date is not treated as ordinary income under the regular income tax.

This exclusion is one reason ISOs are often preferred by employees who expect the stock price to rise and who can hold their shares long enough to satisfy the special holding period requirements.

The regular income tax exclusion at exercise does not eliminate all exposure. The IRS states that you may be subject to alternative minimum tax in the year you exercise an ISO, and refers taxpayers to the Instructions for Form 6251.^[4] The spread between the exercise price and the fair market value on the exercise date is an AMT preference item. If the AMT calculation produces a larger liability than your regular income tax, you pay the difference.

Employees who exercise large ISO tranches in a single year sometimes face a substantial AMT bill even though no shares were sold. Modeling the exposure before you exercise can prevent surprises at filing time. Our advisory solutions team works with equity compensation clients on AMT planning.

When you sell ISO shares, the tax outcome depends on whether you have satisfied the special holding period requirements. If you have not, the IRS will treat income from the sale as ordinary income.^[7] A sale that satisfies those requirements is a qualifying disposition and the gain is generally treated as a capital gain or loss.^[8]

After you exercise an ISO, your employer should provide Form 3921 under Section 422(b).^[6] That form carries the key dates and amounts your tax preparer needs to correctly classify any capital gain and ordinary income on your return.

Non-qualified stock options receive less favorable treatment at exercise. For nonstatutory options without a readily determinable fair market value, no taxable event occurs at the grant date. The IRS requires you to recognize income at exercise equal to the market value of the shares received, reduced by the price you paid.^[5]

In practice, the spread between the exercise price and the fair market value on the exercise date is ordinary income in the year of exercise. Your employer withholds income and payroll taxes on that amount and reports it on your annual wage statement. The amount you paid to exercise becomes your cost basis in the shares for calculating future gain or loss.

A restricted stock unit is not an option to buy shares: it is a promise to deliver shares when you satisfy a vesting condition. There is no tax event at grant and no tax event during the vesting period. The taxable moment arrives when shares vest and are transferred to you.

On the vest date, the fair market value of the delivered shares is ordinary income. That income is subject to withholding and payroll taxes, reported on your employer's annual wage statement. Your cost basis in the vested shares equals the amount included in income on the vest date. Any price movement after vesting is a capital gain or loss depending on how long you hold the shares. Technology and professional-services workers with RSU grants often benefit from proactive planning around withholding elections and sale timing; see our professional services tax help page. Founders and business owners who receive equity grants alongside S-corporation salary should also review S-corp reasonable compensation rules for related compensation planning considerations.