A stock option (Non-Qualified Stock Option) taxed as ordinary income on the spread between strike price and fair market value the moment you exercise, with no special IRS treatment.
ISOs are restricted to W-2 US employees, which leaves NSOs as the only option type that legally fits contractors, board members, advisors, and engineers working abroad. A startup that grants its London designer ISOs is making a paperwork mistake that the law firm will catch at the next financing.
The two flavors of employee stock option in the US. They look the same on the offer letter, but the tax treatment splits them wide open.
| Aspect | NSO | ISO |
|---|---|---|
| Who can receive them | Anyone: employees, contractors, advisors, board members | W-2 US employees only |
| Tax at exercise | Ordinary income tax on the spread, automatically withheld | No regular income tax, but can trigger AMT |
| Tax at sale | Long-term capital gains on any further appreciation | Long-term capital gains if held 2 years post-grant and 1 year post-exercise |
| Common gotcha | Withholding bill at exercise surprises first-time recipients | AMT can hit hard at exercise even before any shares are sold |
| Annual grant cap | No cap | Only $100K worth per year vests as ISO; the rest spills to NSO |