Day 1: ISOs vs. NSOs vs. RSUs – What’s the Difference?

Understanding the Tax Implications of Stock Options

Day 1: ISOs vs. NSOs vs. RSUs – What’s the Difference?

Stock options are one of the most powerful wealth-building tools for employees and startup founders. But they also come with complex tax rules that can create massive tax bills if not managed correctly.

Today, we’re breaking down the three main types of stock-based compensation:

1️⃣ Incentive Stock Options (ISOs) – Favorable tax treatment, but Alternative Minimum Tax (AMT) risk.

2️⃣ Non-Qualified Stock Options (NSOs) – More flexible but taxed as ordinary income.

3️⃣ Restricted Stock Units (RSUs) – No exercise required, but taxed as W-2 income at vesting.

1. Incentive Stock Options (ISOs) – The Tax-Advantaged Unicorn

ISOs are a golden ticket for employees because they allow you to pay capital gains tax instead of ordinary income tax—if you follow the rules.

🚀 How They Work:

✅ You receive an option grant (usually at a discount).

✅ You exercise the options and buy shares.

✅ If you hold for 2+ years from grant and 1+ year from exercise, you only pay long-term capital gains tax on the profit.

🔻 The Catch?

• No tax at exercise, BUT…

• You might owe Alternative Minimum Tax (AMT) (we’ll discuss this in Day 2).

💡 Example:

• Sarah is granted 10,000 ISOs at $5 per share.

• She exercises when the stock is $20 per share (paper gain = $150,000).

• If she sells after 1+ years, she only pays long-term capital gains tax—saving thousands!

📌 Cited in IRC: ISOs are governed by IRC § 422.

2. Non-Qualified Stock Options (NSOs) – More Common, But Less Favorable

NSOs don’t get special tax treatment like ISOs. Instead, when you exercise, the difference between the strike price and fair market value (FMV) is taxed as ordinary income.

🚀 How They Work:

✅ You receive an option grant.

✅ When you exercise, the “spread” (FMV - strike price) is taxed as W-2 income.

✅ When you sell, you pay capital gains tax on any further appreciation.

💡 Example:

• Jake receives 10,000 NSOs at $5 per share.

• He exercises when the stock is $20.

• That $150,000 spread is taxed as ordinary income—ouch.

• If he holds and sells at $30, he pays capital gains tax on the $10 difference.

📌 Cited in IRC: NSOs are covered under IRC § 83 and IRC § 409A.

3. Restricted Stock Units (RSUs) – Simple, But Tax-Heavy

RSUs are not options—they are actual shares that vest over time. Unlike ISOs and NSOs, you don’t need to exercise RSUs—they just become yours.

🚀 How They Work:

✅ RSUs automatically vest over time.

✅ The value at vesting is taxed as W-2 income.

✅ If you hold and sell later, you pay capital gains tax on any increase.

💡 Example:

• David gets 10,000 RSUs.

• When they vest at $50 per share, he owes ordinary income tax on $500,000.

• If he holds and sells at $70 per share, he pays capital gains tax on the $200,000 gain.

📌 Cited in IRC: RSUs are governed by IRC § 83.

Tomorrow’s Topic: ISOs & AMT – What You Need to Know Before Exercising

Think ISOs are tax-free when you exercise? Think again. The Alternative Minimum Tax (AMT) trap could surprise you with a huge tax bill—even if you don’t sell a single share.

Got questions? Drop them in the comments or message me!