https://carta.com/blog/equity-101-exercising-and-taxes/
So you want to understand how stock options are taxed, but you’re not sure where to begin. In this article, we’ll break down the different types of stock options and how tax treatment works for each. We’ll also cover holding periods, ordinary income tax vs. capital gains tax, and alternative minimum tax.
Ready? Let’s go.
What you’ll learn:
A stock option is a type of equity compensation that allows employees and other service providers to buy shares in the company. Stock options aren’t actual shares of stock—they’re the right to buy a set number of shares at a fixed price, usually called a strike price, or exercise price. Your purchase price stays the same over time, so if the value of the stock goes up, you could make money on the difference. You may also have to pay taxes on that difference.
→ Learn more about how stock vesting works
Two types of employee stock options are available in the United States: incentive stock options (ISOs) and non-qualified stock options (NSOs). They both function the same way: They allow you to be a partial owner in your company. ISOs and NSOs mainly differ in how and when they’re taxed—ISOs could qualify for favorable tax treatment.
Instead of stock options, some companies offer alternative types of equity awards, such as restricted stock awards (RSAs) or restricted stock units (RSUs). These aren’t the same as stock options and are treated differently by the IRS for tax purposes.
Stock options are typically taxed at two points in time: first when they are exercised (purchased) and again when they’re sold. You can unlock certain tax advantages by learning the differences between ISOs and NSOs.
| ISO | NSO | |
|---|---|---|
| Exercise | May be subject to alternative minimum tax (details below) | May be subject to ordinary income tax |
| Sell | Ordinary income or capital gains | Capital gains |
When you exercise your stock options, your potential tax liability is determined by the difference between your strike price (fixed purchase price) and the current fair market value (FMV) of those stock options. This difference is often referred to as the “spread.”
For NSOs, the spread is taxable as ordinary income and your company will usually withhold taxes (including federal, payroll and any applicable state taxes) on the spread when you exercise.
For example, if you exercise 100 vested NSOs at a grant price of $1 and the current value is $3, you’ll pay ordinary income tax on the $200 gain at exercise.
For ISOs, instead of the spread being includable in ordinary income tax, it is included as income in something called the alternative minimum tax (AMT) calculation, which could trigger additional taxes owed when you file your tax return.