The three most common forms of startup and public-company equity — RSUs, ISOs, and NSOs — are taxed in three genuinely different ways, and mixing them up on your tax return is one of the most expensive mistakes an employee can make. One triggers ordinary income the moment shares vest. One can effectively be taxed twice — once under the regular system, once under the alternative minimum tax — if you're not careful. One is straightforward ordinary income at exercise with no AMT angle at all. Same category, "equity compensation," three different tax bills.
If your offer letter uses these terms interchangeably, it's worth stopping to get this right before you exercise, vest, or sell anything.
Key Takeaways
- RSUs are taxed as ordinary income at vesting, full stop. There's no election to defer or reduce that income — the value of the shares on the vesting date becomes W-2 wages, whether or not you sell.
- ISOs can qualify for capital gains treatment, but only if you clear two holding-period tests — two years from grant, one year from exercise. Miss either one and it becomes a "disqualifying disposition," taxed largely as ordinary income instead.
- ISOs carry an AMT trap that RSUs and NSOs don't. Exercising and holding ISO shares past year-end can create phantom income for alternative minimum tax purposes, even though you haven't sold anything or received any cash.
- NSOs are the simplest of the three, tax-wise, but not the cheapest. The spread between exercise price and fair market value is ordinary income at exercise, subject to withholding — there's no capital gains path for that first slice of value.
- The "right" instrument depends on your cash flow, AMT exposure, and how much risk you're willing to take on the exercise cost itself — this is a planning question, not a one-size-fits-all rule.
What each one is and how the rule works
All three sit under the broader umbrella of equity compensation — part of what we call the alphabet soup of equity compensation — but they're governed by different code sections, and that's exactly why the tax outcomes diverge.
RSUs (restricted stock units) are a promise to deliver shares once vesting conditions are met — no stock transferred at grant, just a contractual right. Under IRC Section 83(a), the fair market value becomes taxable ordinary income the moment shares vest, since that's when "property" is actually transferred. Your employer reports this on your W-2 and generally withholds income and payroll taxes at vesting — see what you need to know about restricted stock units for a deeper look.
ISOs (incentive stock options) only exist, tax-wise, if they meet IRC Section 422: granted under a written plan, exercise price at least equal to grant-date fair market value, a $100,000 annual vesting-value limit, and other technical requirements. Hold the resulting shares at least two years from grant and one year from exercise (a "qualifying disposition"), and the entire gain is taxed as long-term capital gain — no ordinary income along the way. Sell earlier and it's a "disqualifying disposition," below. For the full mechanics, see how incentive stock options are taxed.
NSOs (nonqualified stock options) are the default bucket for any option that doesn't meet the ISO requirements — often used deliberately for contractors, advisors, or higher-value grants. Governed by the general rule of IRC Section 83: the spread between exercise price and fair market value at exercise is ordinary income, taxed and withheld immediately, regardless of how long you hold the shares afterward. Our ISO vs. NSO tax guide walks through this side-by-side comparison in more detail.
The AMT wrinkle that makes ISOs different
Here's the rule that catches people: exercising an ISO and holding the shares past December 31 of that year can trigger the alternative minimum tax, even though you received no cash and sold nothing.
Under IRC Section 56(b)(3), the bargain element on an ISO exercise — FMV at exercise minus exercise price — is added back as a preference item when calculating alternative minimum taxable income, as long as shares are still held at year-end. It doesn't touch regular taxable income, but it can be large enough to owe AMT on income you haven't converted to cash. IRS Form 6251 instructions detail the calculation.
Doesn't AMT eventually true up? Often, yes — you may generate a minimum tax credit offsetting regular tax in future years. That credit doesn't help your bank account the year you owe AMT on stock you can't yet sell. Selling ISO shares in the same calendar year as exercise removes the Section 56(b)(3) preference entirely, since the sale becomes a disqualifying disposition taxed under the regular system instead — a real, if narrow, escape valve some employees use deliberately.
Disqualifying dispositions: when an ISO stops acting like an ISO
An ISO becomes a disqualifying disposition if you sell before satisfying both IRC Section 422 holding periods. The bargain element at exercise (FMV minus exercise price, or actual gain if lower) is then taxed as ordinary income in the year of the disqualifying sale, not capital gain; additional appreciation is short- or long-term capital gain depending on holding period; and the AMT preference from the exercise year unwinds since the income is now captured under the regular system.
ISOs are sometimes called "capital gains treatment with training wheels" — the benefit is conditional, and easy to trip with an early sale, a tender offer, or a forced acquisition sale.
Why it matters: a worked numeric example
Consider an illustrative employee, Marcus, who receives equity in a private company currently valued at $14 per share.
RSUs: Marcus has 2,400 RSUs that vest when the stock is worth $14/share. At vesting, $33,600 (2,400 × $14) becomes ordinary income on his W-2 — regardless of whether he sells. If the stock later rises to $19/share and he sells, the additional $12,000 gain (2,400 × $5) is capital gain, short- or long-term depending on his holding period after vesting.
ISOs: Marcus exercises 2,400 ISOs with a $6 strike price when the stock is worth $14/share. His exercise cost is $14,400, and the bargain element is $19,200 (2,400 × $8). If he holds past year-end, that $19,200 becomes an AMT preference item — no regular tax due yet, but potentially a real AMT bill. If he later sells after meeting both the 2-year and 1-year tests at $19/share, his entire gain of $31,200 (2,400 × $13) is long-term capital gain — none of it ordinary income.
NSOs: Marcus exercises 2,400 NSOs at the same $6 strike price when the stock is worth $14/share. The $19,200 bargain element is ordinary income immediately at exercise, subject to withholding — no AMT question, but no deferral either. If he later sells at $19/share, the additional $12,000 of appreciation is capital gain from the exercise date forward.
| Feature |
RSU |
ISO (qualifying) |
NSO |
| Taxable event |
Vesting |
Sale (if qualifying) |
Exercise |
| Character of bargain element |
Ordinary income |
Capital gain (if qualifying) |
Ordinary income |
| Withholding at vest/exercise |
Yes |
No |
Yes |
| AMT exposure |
No |
Yes, if shares held past year-end |
No |
| Risk if sold early |
N/A |
Disqualifying disposition → ordinary income |
N/A |
These figures are illustrative only, designed to show the mechanics — actual dollar amounts depend on your specific grant terms, strike price, vesting schedule, and the stock's value at each relevant date.
How it works in practice: withholding and reporting
- RSUs: employers typically withhold via "sell-to-cover" — selling a portion of vesting shares. Shows up on your W-2 as ordinary wages, with a 1099-B for any later sale of remaining shares.
- ISOs: no withholding at exercise for a qualifying disposition — you need cash for the exercise price and should plan separately for AMT. Your company reports the exercise on Form 3921, needed for your AMT adjustment and basis.
- NSOs: exercise triggers withholding like a paycheck — income tax, Social Security, and Medicare withheld from the spread.
- All three: keep every exercise confirmation and Form 3921/3922 — cost basis errors are among the most common and expensive equity-comp mistakes, since brokerages often report an incomplete basis on Form 1099-B.
The catch
RSUs give you zero control over timing. Income hits at vesting whether the stock is up or down, and whether you have cash for the tax bill (private-company RSUs with no liquid market are a particular pain point).
ISOs' capital gains benefit is conditional and fragile. An acquisition, forced tender, or your own need for cash before the holding periods are met can wipe out the tax advantage entirely.
AMT on ISOs can create a cash crunch — a real tax bill on shares you can't sell, which has burned employees at companies whose value later declined.
NSOs offer no deferral on the spread. You pay ordinary rates on the full bargain element at exercise even if you plan to hold the shares for years.
None of these are mutually exclusive — many employees hold a mix, and the planning question is how they interact, not which one "wins."
Strategy: what to actually do
- Model AMT exposure before exercising a large ISO grant, especially in a year with other significant income.
- Track ISO holding-period deadlines on a calendar — the two-year-from-grant and one-year-from-exercise dates are easy to miscalculate, and missing them converts capital gain into ordinary income.
- Consider an early exercise plus 83(b) election for ISOs or NSOs with a vesting schedule — see our companion article on the 83(b) election for the mechanics and the strict 30-day deadline.
- Don't assume your broker's reported cost basis is correct — many 1099-Bs omit the compensation-income component already taxed through payroll.
- Revisit your equity mix with each new grant — the "default" instrument a company offers isn't always what's best for you.
Where a tax advisor earns their fee
Comparing RSUs, ISOs, and NSOs on paper is one thing; modeling actual AMT exposure, choosing which shares to exercise and when, and coordinating an exercise with the rest of your income is a different exercise entirely — one where a specialist advisor's judgment is worth real money. If you're still working out what questions to even ask, our list of questions to ask about your startup equity compensation is a good starting point. Harness connects employees and founders with tax advisors who work with RSUs, ISOs, and NSOs regularly, so exercise and AMT decisions get made with real numbers instead of guesswork.
Putting it all together
Before your next vesting date, exercise, or sale, confirm:
- What kind of equity you actually hold — RSU, ISO, or NSO — since the tax treatment is not interchangeable.
- Where you stand on the relevant clock — vesting date for RSUs, the two-holding-period test for ISOs, or exercise date for NSOs.
- Whether an ISO exercise creates AMT exposure this year, and whether you can cover the exercise cost and any resulting tax without a forced sale.
Once you know where each grant stands, a tax advisor can help sequence exercises and sales to fit your broader financial picture.
Frequently Asked Questions
Are ISOs always better than NSOs? Not necessarily. ISOs offer a path to capital gains treatment, but only if you meet strict holding-period rules and can afford the exercise cost and any AMT exposure without selling shares. NSOs are simpler and more predictable but tax the full bargain element as ordinary income immediately.
Do RSUs ever get capital gains treatment? The value at vesting is always ordinary income. Only appreciation after vesting can qualify for capital gains treatment, short- or long-term depending on how long you hold after vesting.
Can I file an 83(b) election on my RSUs? Generally, no. RSUs are an unfunded promise to deliver shares later, not a transfer of property at grant, so there's nothing to elect on under IRC Section 83(b) until the shares actually vest.
What triggers AMT on an ISO exercise? Exercising an ISO and holding shares past December 31 of the exercise year creates an AMT preference item under IRC Section 56(b)(3) — the spread between fair market value and exercise price. Selling in the same year (a disqualifying disposition) removes this preference but converts the gain to ordinary income.
What is a disqualifying disposition? A sale of ISO shares before meeting both holding periods — two years from grant, one year from exercise — under IRC Section 422. The bargain element is then taxed as ordinary income rather than capital gain.
Do NSOs have any capital gains benefit at all? Only on appreciation after exercise. The spread at exercise is always ordinary income; further appreciation before sale can be short- or long-term capital gain depending on holding period from the exercise date.
Where can I read the actual tax code sections? IRC Section 83 is at law.cornell.edu/uscode/text/26/83. IRC Section 422 (ISOs) is at law.cornell.edu/uscode/text/26/422. IRC Section 56(b)(3) (AMT preference) is at law.cornell.edu/uscode/text/26/56.
Disclaimer:
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