How Employee Stock Options Are Taxed: ISOs, NQSOs, and AMT

Employee stock options are taxed in up to two stages: once when you exercise the option to buy the shares, and again when you sell them. Which stage costs you what depends on whether your grant is a Non-Qualified Stock Option (NQSO) or an Incentive Stock Option (ISO). NQSOs trigger ordinary income tax at exercise. ISOs defer regular income tax until sale, but the Alternative Minimum Tax can still bite at exercise. For 2026, ordinary income from options can be taxed at rates up to 37%, while long-term capital gains top out at 20%.

The Vocabulary You Need First

The exercise price (or strike price) is the fixed per-share amount you pay to buy stock under the option. Companies typically set it equal to the stock’s fair market value on the grant date. The vesting schedule controls when you can actually use the options. Some plans vest all at once; others release portions over several years.

When you exercise, you pay the exercise price and take ownership of the shares. The spread (sometimes called the bargain element) is the difference between the stock’s current fair market value and your exercise price. Exercise price $10, stock worth $40 on exercise day, spread of $30 per share. That spread is the number that drives your tax bill, and the rules for taxing it diverge sharply between NQSOs and ISOs.

How NQSOs Are Taxed

NQSOs follow the general rules for property received in exchange for services under Internal Revenue Code Section 83. Nothing is taxed at grant, because unvested options have no readily ascertainable value. The tax event is exercise.¹

Ordinary Income at Exercise

The entire spread is taxed as ordinary income, exactly like salary. In 2026, the top federal rate of 37% kicks in above $640,600 of taxable income for single filers and $768,700 for married couples filing jointly.² Your employer treats this as compensation. It appears in Box 1 of your W-2, is separately reported in Box 12 with Code V, and is subject to Social Security, Medicare, and income tax withholding.³

Here is where people get burned. Most employers withhold on the NQSO spread at the flat 22% supplemental wage rate, which is well below the actual rate for anyone whose total income pushes into the 32%, 35%, or 37% bracket. A large exercise can leave you tens of thousands short at filing time. To avoid an underpayment penalty, you need to have paid at least 90% of your current-year tax through withholding and estimated payments, or 100% of last year’s tax (110% if your prior-year adjusted gross income exceeded $150,000).

Capital Gains When You Sell

The second taxable event is the sale. Your cost basis equals what you paid to exercise plus the ordinary income already recognized. In the earlier example, $10 exercise price plus $30 of taxed spread gives an adjusted basis of $40. Any gain above that basis is a capital gain. Hold the shares more than one year after exercise and the profit is long-term, taxed at 0%, 15%, or 20% depending on income. For 2026, single filers pay 0% on long-term gains up to $49,450 of taxable income, 15% up to $545,500, and 20% above that.² Sell within a year of exercise and the gain is short-term, taxed at ordinary rates.

Watch the cost basis on your Form 1099-B. Brokerages often report only the exercise price, ignoring the ordinary income you already paid tax on. If you don’t correct that on Form 8949, you appear to have a much larger capital gain than you actually do, and you end up paying tax twice on the same dollars. Check your broker’s supplemental statement for the adjusted basis and use that figure in column (e), or enter the unadjusted basis and make the correction in column (g).

How ISOs Are Taxed

ISOs get more favorable treatment under the tax code, but the rules are stricter. Follow them and your entire profit can be taxed as a long-term capital gain. Miss a requirement and part or all of the gain reverts to ordinary income.⁴

No Regular Tax at Exercise

Under IRC Section 421(a), no regular federal income tax is owed at ISO exercise as long as the holding period requirements are met and you remain employed (or exercise within three months of leaving).⁵ That deferral is the main appeal of ISOs.

The AMT Catch

The deferral is not free. Under IRC Section 56(b)(3), the Section 421 exemption does not apply for Alternative Minimum Tax purposes, so the full spread at exercise gets added to your income when you calculate AMT.⁶

AMT works like a parallel tax system: you compute your regular tax, recompute using AMT rules, and pay the higher amount. For 2026, the AMT exemption is $90,100 for single filers and $140,200 for married couples filing jointly, with phaseouts starting at $500,000 and $1,000,000.² The AMT rates are 26% and 28%. A large ISO exercise is one of the most reliable triggers of AMT liability.

If AMT pushes your bill above the regular tax, the extra you paid can be carried forward as a Minimum Tax Credit on Form 8801 and used against regular tax in future years.⁷ The credit carries forward indefinitely, though you may not be able to use much of it until you sell the shares or your income mix shifts.

The $100,000 Annual Limit

Only $100,000 worth of ISOs (measured by fair market value at grant) can become exercisable for the first time in any calendar year. Anything above that automatically converts to NQSO treatment, counted in the order the grants were made.⁸ The limit matters most when vesting schedules from multiple grants overlap.

Holding Periods and Disqualifying Dispositions

To get the full ISO benefit, you must satisfy two holding periods: at least two years from the grant date and at least one year from the exercise date.⁴ Clear both and the entire gain from exercise price to sale price is a long-term capital gain.

Sell before either deadline and you have a disqualifying disposition. The gain up to the exercise-date spread converts to ordinary income and shows up on your W-2. Any additional appreciation beyond the exercise-date value is a capital gain, short- or long-term depending on how long you held after exercise.

NQSO holding periods are simpler because you already paid ordinary income tax at exercise. The clock for long-term capital gains starts the day after exercise, and more than one year of holding gets you the preferential rate.⁹

Leaving the Company

Departure starts an ISO clock. To preserve ISO treatment, you must exercise within three months of your last day of employment. After that, unexercised ISOs either expire under most plans or convert to NQSOs and lose their tax advantage.⁴ The window extends to one year if you leave because of disability.

Some companies offer extended post-termination exercise windows. Once the window runs past three months, the options automatically become NQSOs, and the spread at exercise becomes ordinary wages subject to full income and employment taxes. NQSOs themselves face no equivalent three-month rule, though most plans impose their own contractual expiration dates after termination.

Early Exercise and the 83(b) Election

Some startup plans let you exercise options before they have vested. Because unvested stock is restricted property, Section 83 would normally defer the tax until vesting. A Section 83(b) election flips that: you recognize the income immediately, at the pre-appreciation value.

The election must be filed with the IRS within 30 days of exercise. Miss the deadline and it is gone permanently. When the exercise price equals current fair market value, an 83(b) election can lock in little or no tax up front, and any later appreciation qualifies for capital gains treatment if you hold long enough. The risk is symmetric: if the stock drops or the company fails, you have paid tax on income you never received, and you cannot recover it. The math typically favors early-stage startup employees with low share values, not employees of publicly traded companies whose shares already carry substantial value.

Extra Taxes That Can Apply

Additional Medicare Tax

Ordinary income from NQSO exercise counts as wages for Medicare. Once total wages exceed $200,000 (single) or $250,000 (married filing jointly), the Additional Medicare Tax of 0.9% is added on top of the standard 1.45% Medicare rate. Employers begin withholding it once your wages with them pass $200,000, regardless of filing status, so a joint filer with two incomes can still owe more at filing time.¹⁰

Net Investment Income Tax

The 3.8% Net Investment Income Tax applies to investment income (including capital gains) once modified adjusted gross income exceeds $200,000 (single) or $250,000 (married filing jointly). Those thresholds are not indexed for inflation.¹¹ NIIT does not apply to wages, so the ordinary income from NQSO exercise is outside its reach. Capital gains on shares acquired through either NQSOs or ISOs, however, can trigger it.¹²

Reporting Option Income to the IRS

NQSO income flows through your W-2. Box 1 already includes the spread as part of total wages, and Box 12 Code V shows the amount separately so you can verify it.³ No separate IRS form is filed for the exercise itself.

For ISO exercises, your company files Form 3921 reporting the grant date, exercise date, exercise price, and fair market value at exercise. You use that form to compute the AMT preference on Form 6251.¹³¹⁴

Sales go on Form 8949 and Schedule D. ISO sales that clear both holding periods are reported straight through as long-term capital gains. Disqualifying dispositions require splitting the gain: the ordinary income portion runs through your W-2 while any remaining capital gain lands on Form 8949. If AMT was triggered in an earlier exercise year, Form 8801 is where you claim the Minimum Tax Credit when circumstances allow you to use it.¹⁵ And on any NQSO sale, verify the cost basis before you file. Correcting the 1099-B is the single most common step people miss, and it is the difference between paying tax once and paying it twice.

1
Office of the Law Revision Counsel. 26 U.S. Code 83 – Property Transferred in Connection With Performance of Services
2
Internal Revenue Service. IRS Releases Tax Inflation Adjustments for Tax Year 2026
3
Internal Revenue Service. 2026 General Instructions for Forms W-2 and W-3
4
Office of the Law Revision Counsel. 26 U.S. Code 422 – Incentive Stock Options
5
Office of the Law Revision Counsel. 26 U.S. Code 421 – General Rules
6
Office of the Law Revision Counsel. 26 U.S. Code 56 – Adjustments in Computing Alternative Minimum Taxable Income
7
Internal Revenue Service. Instructions for Form 8801
8
Office of the Law Revision Counsel. 26 USC 422 – Incentive Stock Options
9
Internal Revenue Service. Topic No. 409, Capital Gains and Losses
10
Internal Revenue Service. Questions and Answers for the Additional Medicare Tax
11
Internal Revenue Service. Questions and Answers on the Net Investment Income Tax
12
Internal Revenue Service. Net Investment Income Tax
13
Internal Revenue Service. Form 3921 – Exercise of an Incentive Stock Option Under Section 422(b)
14
Internal Revenue Service. Instructions for Form 6251
15
Internal Revenue Service. About Form 8801, Credit for Prior Year Minimum Tax – Individuals, Estates, and Trusts