Two Types of Stock Options, Two Very Different Tax Outcomes
When a company grants you stock options, the type of option matters enormously for tax purposes. Non-Qualified Stock Options (NSOs) and Incentive Stock Options (ISOs) are taxed under fundamentally different rules, and understanding which you have is the first step to planning your exercise strategy.
NSOs: Non-Qualified Stock Options
NSOs are the simpler of the two types in terms of tax mechanics, and they're more common — private companies, public companies, and non-employee grants (advisors, consultants) frequently use NSOs.
When you exercise an NSO, the difference between the exercise price (the price you pay) and the fair market value of the stock on the exercise date is called the "spread." This spread is taxed as ordinary income in the year of exercise, subject to all the usual taxes: federal income tax, NY State income tax, NYC local income tax, Social Security, and Medicare.
NSO Exercise Example
You hold 1,000 NSOs with a strike price of $10. The stock is now worth $40. You exercise all 1,000 options.
| Item | Amount |
|---|---|
| Spread per share ($40 - $10) | $30 |
| Total spread (1,000 × $30) | $30,000 |
| Federal income tax (32% marginal) | $9,600 |
| NY State tax (6.85%) | $2,055 |
| NYC local tax (3.876%) | $1,163 |
| Medicare + additional Medicare (2.35%) | $705 |
| Total tax on exercise | ~$13,523 (45%) |
Your cost basis in the shares after exercise is $40 (the FMV on exercise date). If you later sell at $60, you have a $20/share capital gain. If sold within one year of exercise, it's taxed as short-term ordinary income. If held more than one year, it's long-term capital gains (preferential federal rates apply; NY and NYC still tax at ordinary rates).
Employer withholding on NSOs: Unlike RSUs, some employers don't automatically withhold taxes on NSO exercises — especially at private companies. Make sure you know whether your employer will withhold or whether you're responsible for making estimated tax payments when you exercise.
ISOs: Incentive Stock Options
ISOs receive more favorable federal tax treatment, but they come with strict rules and a significant complication: the Alternative Minimum Tax (AMT).
When you exercise an ISO, there is no regular federal income tax due at exercise — unlike NSOs. This is the big benefit. However, the spread at exercise is an AMT preference item, which may trigger AMT liability. If you hold the shares for at least two years from the grant date AND at least one year from the exercise date (a "qualifying disposition"), any gain on the eventual sale is taxed at long-term capital gains rates — not ordinary income rates.
ISO Qualifying Disposition Requirements
- Hold shares at least 2 years from grant date
- Hold shares at least 1 year from exercise date
- You must be an employee when the option is granted and through exercise
- Exercise price must equal or exceed FMV at grant date
The Alternative Minimum Tax (AMT) and ISOs
The AMT is a parallel tax system designed to ensure high earners pay at least a minimum amount of tax. For ISO holders, the spread at exercise is added to your AMT income as a "preference item," even though it's not subject to regular income tax.
The AMT rate is 26% on the first $220,700 of AMT income (above the exemption) and 28% on amounts above that for 2026. If your calculated AMT exceeds your regular tax, you pay the difference as AMT.
AMT Example
You earn $120,000 salary and exercise ISOs with a $200,000 spread. Your regular tax on $120,000 might be ~$24,000. But your AMT income is $120,000 + $200,000 = $320,000. After the AMT exemption (~$88,100 for single filers in 2026), your AMT income is ~$231,900. AMT at 26% = ~$60,294. Your AMT liability is roughly $60,294 - $24,000 = $36,294 additional tax owed.
New York State has its own AMT (generally conforming to the federal AMT structure). New York City does not have a separate AMT but does tax all ordinary income at city rates.
AMT credit: The AMT you pay on ISO exercises creates an AMT credit that can offset future regular tax liability in years when your regular tax exceeds your AMT. The credit carries forward indefinitely, but you can only use it in years with a regular tax surplus over AMT — which can take many years to fully recover.
The 83(b) Election: Early Exercise of Unvested Options
Some companies allow employees to exercise options before they've fully vested — known as "early exercise." If you do this, you can file an 83(b) election with the IRS within 30 days of exercise to elect to pay tax now on the current spread (often near zero if exercised at grant when FMV equals strike price) rather than when the shares vest.
The 83(b) election can be extraordinarily powerful: if you exercise early when the spread is $0 or very small (common at early-stage startups right after grant), you owe nearly nothing in tax at that time. Your holding period for capital gains begins immediately. Years later when shares have appreciated dramatically, all that appreciation is taxed as long-term capital gains rather than ordinary income.
The 30-day deadline is absolute — missing it eliminates this option entirely. The election must be filed with the IRS by mail (certified mail recommended) and a copy provided to your employer.
83(b) Election Example: The Potential Tax Savings
| Scenario | Without 83(b) | With 83(b) Election |
|---|---|---|
| 10,000 ISOs, strike $5, FMV at grant $5 | — | Tax on $0 spread = $0 |
| FMV at full vesting (4 years later): $25 | Ordinary income on $20 spread × 10,000 = $200,000 | No ordinary income event |
| Federal + NY + NYC tax on vest income | ~$90,000–$100,000 | $0 at vesting |
| Sale after 1+ year from exercise | LTCG on appreciation from vest price | LTCG on full $20+ appreciation |
QSBS Exclusion (Section 1202): Federal Benefit, NYC Doesn't Conform
Section 1202 of the Internal Revenue Code provides that gains from the sale of Qualified Small Business Stock (QSBS) held more than 5 years may be excluded from federal income tax — up to 100% of gains up to $10 million (or 10x basis). This can be a massive benefit for startup employees who hold stock in qualifying C-corporations.
However, New York State and New York City do not conform to the Section 1202 exclusion. Gains that are 100% federally tax-free are still fully taxable for NY and NYC purposes. At a combined NY State + NYC rate of up to 13.5%, a $5 million gain that's federally exempt could still trigger $675,000 in state and city tax. QSBS planning for NYC residents must account for this non-conformity.
Frequently Asked Questions
Should I exercise my ISOs before the end of the year?
Exercising ISOs before December 31 can start the one-year holding period required for long-term capital gains treatment. However, the spread at exercise is an AMT preference item — so exercising late in the year gives you less time to understand your AMT exposure before the tax filing deadline. Modeling your full-year AMT position before exercising is essential. A CPA familiar with equity compensation can help project the impact.
How does NYC treat QSBS gains?
New York City does not conform to the federal Section 1202 QSBS exclusion. Gains that are 100% federally excluded are still fully taxable for both NY State and NYC local tax purposes. This is a critical planning point for NYC-based startup founders and employees — the state and city tax bill on a QSBS gain can be substantial even when the federal bill is zero.
What happens to my stock options if I leave NYC?
If you leave NYC and later exercise NSOs or ISOs, New York may still claim a portion of the gain. NY allocates equity income based on the ratio of days worked in New York during the option vesting period to total vesting-period days. Even if you've moved to another state, some portion of the gain may still be allocated to NY — particularly for options that vested while you were in NYC. This is an area where professional tax advice is strongly recommended before you exercise.
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