Startup stock options: ISO vs NSO tax, the $100,000 limit, 409A and Rule 701

Part of the equity and finance team section. This page covers the United States federal income tax treatment as set out in IRS Topic 427, Publication 525 (2025 edition) and section 422 of the Internal Revenue Code, 2024 edition. State tax, non-U.S. rules, the AMT credit and qualified small business stock are outside its scope, and your own facts will differ, so use it to understand the rules before talking to a tax adviser.

Terms you will meet

Five terms carry most of this page. Each is defined here once and used the same way below.

• Strike price. The agreed price per share you pay to exercise⁶.
• Readily determinable value. An option has one when it is actively traded on an established market, or when it is untraded but you can transfer it and exercise it immediately in full, among other conditions^{1, 2}.
• Substantial risk of forfeiture. Your rights to the property depend on you performing substantial services in the future, so unvested stock can still be taken back⁴.
• Disqualifying disposition. Selling ISO stock before the holding periods are met, which turns part of the gain into ordinary income^{1, 2}.
• Alternative minimum tax (AMT). A parallel tax calculation in which the gain on ISO stock at exercise counts as an adjustment even though regular tax ignores it².

Before reading further, pull out your grant paperwork and check four things. The label comes first: does the grant call the option an incentive stock option or a nonstatutory one? It decides which column of every table below applies¹. Then the strike price, which you should compare with the fair market value on the grant date, and ask how the company set that value (the 409A section below)¹⁰. Third, the vesting terms, which can be time served or performance milestones and decide when stock stops being forfeitable⁶. Last, the exit rules: for an ISO you must be an employee from grant until 3 months before exercise (1 year if disabled), so ask what happens to your options when you leave³.

ISO vs NSO: key differences

Startups hand out options as part of pay⁶. What follows depends on one thing: the tax category the option was granted under. A statutory option generally carries no income at grant or exercise. A nonstatutory option turns on whether it has a readily determinable fair market value, and most do not, so the stock’s value at exercise, less what you paid, becomes income when you exercise¹.

Telling an ISO from an NSO

Ask your employer which kind you hold². The grant paperwork settles it, because the type is fixed by how the option was granted: options under an employee stock purchase plan or an ISO plan are statutory, and anything granted under neither is nonstatutory¹.

An option can also lose its ISO status. If you do not meet the employment requirements, or you receive a transferable option, the option is a nonstatutory stock option². And an option over the annual dollar limit, covered below, is treated as not being an ISO to that extent³.

After an ISO exercise, the corporation files a Form 3921 and furnishes a statement to the person named on it⁵. After an exercise of a nonstatutory option, the amount appears on the W-2 with code V².

Tax treatment at grant, exercise and sale

Grant

A statutory option creates no income when you receive it. A nonstatutory option can, but only if its value is readily determinable. Most are not, so there is nothing to report until you exercise or transfer the option².

That is a high bar. An option actively traded on an established market clears it¹. An untraded option clears it only if every condition on a list holds, including that you can transfer it and exercise it immediately in full².

Exercise

The basis in stock acquired under a nonstatutory option is the amount paid plus any amount included in income at grant or exercise².

Sale

Sell the shares and you have a taxable gain or a deductible loss, generally capital¹. The ISO exception is the one to remember: sell before the holding periods are met and the income is ordinary instead¹.

The $100,000 limit on ISO treatment

The Code caps ISO treatment at $100,000 of stock a year. Add up the fair market value of the stock under every ISO that first becomes exercisable for one person in a calendar year, across all plans of the employer and its parent and subsidiaries. Anything over $100,000 is treated as a nonstatutory option³.

That is the 2024 edition of the Code, the latest on govinfo.gov when we checked on October 21, 2026³. Three details complete the rule:

• The limit counts options by when they first become exercisable, not when they were granted³.
• Options are taken into account in the order in which they were granted³.
• The fair market value of the stock is determined as of the time the option is granted³.

An option over the limit does not disappear. To that extent it is treated as an option which is not an incentive stock option, which puts it among the options granted under neither plan type^{3, 1}.

ISO requirements, one by one

An option is an ISO only if it meets every item in the statute³.

Two special rules adjust the table. For a 10-percent shareholder, the ownership limit is lifted if the option price is at least 110 percent of fair market value and the option is not exercisable after 5 years from grant³. For a disabled employee, the 3-month employment period becomes 1 year³.

The Code also forgives a good-faith valuation mistake. If there was a failure in an attempt, made in good faith, to meet the price requirement, the requirement is considered to have been met³. And an option does not stop being an ISO because the employee may pay for the stock with stock of the corporation granting the option³.

An option is also not an ISO if an election is made under section 83(i) with respect to the stock received on its exercise³.

The 409A valuation behind your strike price

A private company has no market price, so someone has to decide what a share is worth on the grant date. That number matters because of section 409A of the Internal Revenue Code, which governs deferred compensation¹⁰. An option whose exercise price is or could become less than the fair market value of the stock on the date of grant generally counts as deferred compensation under the Treasury regulation⁸. Incentive stock options and employee stock purchase plan options are carved out of that rule, and an ISO’s price requirement sits in its own statute^{8, 3}.

For a nonstatutory option, the safe route is simple to state. The exercise price may never be less than the fair market value of the underlying stock on the date the option is granted, and the number of shares is fixed at grant⁸. A “409A valuation” is the work a private company does to show that its fair market value was set reasonably¹⁰.

How a company proves the value was reasonable

The regulation does not leave “reasonable” open. It presumes certain methods are reasonable, and the tax authority can rebut a presumption only by showing the method or its application was grossly unreasonable⁸.

The start-up route has conditions of its own, and a written report alone does not meet them.

• Company profile. No material trade or business conducted for 10 years or more, and no class of equity securities traded on an established securities market⁸.
• No buy-back rights. The stock cannot be subject to a put, call or other right or obligation of the company or another person to purchase it⁸.
• A qualified valuator. The company must reasonably determine that the person doing the work is qualified, and significant experience generally means at least five years in business valuation or appraisal, financial accounting, investment banking, private equity, secured lending or comparable work⁸.
• No imminent event. The route is unavailable when a change in control is reasonably anticipated within 90 days of the action the valuation supports, or a public offering within 180 days⁸.

The independent appraisal route has its own technical test: the appraisal must meet the requirements of section 401(a)(28)(C) and its regulations⁸.

When a valuation goes stale

A 409A value is not good for a fixed year no matter what happens. A previously calculated value stops being reasonable if it fails to reflect information that came out afterward and may materially affect the value of the corporation, such as the resolution of material litigation or the issuance of a patent⁸. It also stops being reasonable if it was calculated for a date more than 12 months before the date it is used⁸. A new priced funding round is the kind of event a finance team treats as fresh information about value, because investors have just put a price on the company. A valuation method is also unreasonable if it ignores available information that is material to the value of the corporation⁸.

What happens when the strike price is too low

A failure under section 409A is costly and it lands on the employee. All compensation deferred under the plan for the year and earlier years becomes includible in gross income to the extent it is not subject to a substantial risk of forfeiture¹⁰. On top of the regular tax, the statute adds an amount equal to 20 percent of the compensation required to be included, plus interest at the underpayment rate plus 1 percentage point¹⁰. That is why founders set the strike price off a written valuation, not off a round number.

The ISO rules handle a missed price differently. A good-faith attempt to meet the ISO price requirement counts as meeting it³. For a nonstatutory grant, the price rule above is the one that protects the employee.

Exercising ISOs: holding period, AMT and disqualifying dispositions

The holding period

The holding period requirement is satisfied when the stock is not sold until the end of the later of the 1-year period after the stock was transferred and the 2-year period after the option was granted². The holding period for the property acquired on exercise begins on the day after the exercise².

The ordinary income is reported by the employer as wages in box 1 of Form W-2². The Code also limits the compensation amount when a disqualifying sale is made at a loss: it shall not exceed the excess of the amount realized over the adjusted basis³.

The IRS gives a case. An employer granted an ISO on March 12, 2023, to buy 100 shares at $10 a share, its FMV at the time². The option was exercised on January 7, 2024, when the stock sold for $12 a share, and the stock was sold on January 27, 2025, for $15 a share². Although the stock was held for more than a year, less than 2 years had passed from the time of grant². In 2025, the difference between the option price ($10) and the value of the stock when exercised ($12) must be reported as wages².

Alternative minimum tax

For the AMT, stock acquired through the exercise of an ISO is treated as if no special treatment applied². When the rights in the stock are transferable or no longer subject to a substantial risk of forfeiture, the amount by which the FMV exceeds the option price is an adjustment in figuring alternative minimum taxable income². No adjustment is required if the stock is disposed of in the same year as the exercise². The AMT basis in the stock is likely to differ from the regular tax basis, so both need to be tracked².

IRS example: an ISO granted on April 8, 2024, for 100 shares at $9 a share, its FMV at the time². It was exercised on January 7, 2025, when the stock sold for $14 a share². On January 27, 2025, with the stock at $16 a share, the rights to the stock first became transferable². The IRS includes $700 ($1,600 value when the rights first became transferable, minus the $900 option price) as an adjustment on Form 6251, line 2i².

Nonstatutory options: when income arises

For a nonstatutory option granted without a readily determinable value, there is no income until the option is exercised or transferred². At exercise, the restricted property rules apply to the property received². If the stock is not substantially vested at exercise, so that the holder may have to give it back, nothing is included until it becomes substantially vested².

The employer reports the amount in box 12 of Form W-2 with code V². Sale of the stock afterward has no special income rules: the sale is reported as a normal sale².

Early exercise, restricted stock and the 83(b) election

Section 83 governs property transferred for services. The value of the property, less any amount paid, is included in gross income in the first taxable year in which the rights are transferable or not subject to a substantial risk of forfeiture⁴. Rights are subject to a substantial risk of forfeiture if full enjoyment of the property is conditioned on the future performance of substantial services⁴.

A person may elect to include the value in gross income in the year of transfer instead⁴. The election must be made not later than 30 days after the date of the transfer⁴. Section 83 does not apply to a transaction to which section 421 applies, the section the ISO statute invokes, nor to the transfer of an option without a readily ascertainable value^{3, 4}.

Restricted stock and restricted stock units are different instruments with different tax consequences⁶. The shares underlying a restricted stock award are owned by the recipient on the date of grant⁶. The holder of an RSU does not own any shares on the date of the grant, because an RSU is a right to receive shares once vesting conditions are met⁶. Vesting conditions may include milestones such as length of employment or performance metrics⁶.

Qualified equity grants: section 83(i)

Section 83(i) lets a qualified employee of a private corporation defer income tax on qualified stock for up to 5 years from the date of vesting². It applies to stock from options exercised or RSUs settled after 2017².

Reporting forms

A Form 3921 is not required for an ISO exercise by a nonresident alien employee to whom no Form W-2 must be provided⁵. For 2025 exercises, the corporation had to furnish the statement by February 2, 2026¹¹. The usual January 31 date fell on a Saturday, and a due date on a Saturday, Sunday or legal holiday moves to the next business day¹¹. Paper filing with the IRS was due March 2, 2026, and e-filing March 31, 2026¹¹. The e-file threshold is 10 returns, aggregated across all information returns⁵.

The next edition of the instructions is not out yet, so the date for this year’s exercises is our projection from the same weekend rule.

Our arithmetic: when the statement is due for exercises this year

ISOs or RSUs: neither wins in general

Neither wins in general, because they trade different things. An ISO is a purchase right. You pay the strike price, regular tax waits until you sell if you meet the holding periods, and you carry an AMT adjustment in the exercise year^{1, 2}. An RSU is a right to receive shares once vesting conditions are met, so you own nothing, and pay nothing, until then⁶. The ISO gives you control over when to exercise and the AMT risk that comes with it. The RSU gives you no exercise decision and a different tax profile⁶. If you are choosing between them, run your own numbers with a tax adviser before the grant, because the answer turns on your income, your company’s plan and what the stock is worth.

Rule 701: how many options a private company can grant

Options are one of several securities a startup issues, beside stock, membership interests, convertible notes and other forms⁶. Rule 701 is the exemption written for paying people with equity. It covers sales made to compensate employees, consultants and advisors in a non-capital raising transaction, and it is not available to Exchange Act reporting companies^{7, 9}. The sale must be under a written compensatory benefit plan or written compensation contract, and consultants and advisors qualify only as natural persons⁹.

Rule 701 is not a way to raise money. It is not available for plans or schemes to raise capital^{7, 9}. Funding rounds rely on other exemptions, such as Rule 506(b) of Regulation D¹², which how venture rounds work walks through, under fundraising mechanics.

The ceiling

The amounts below are as they stand in the eCFR text checked October 21, 2026.

In any consecutive 12-month period, the aggregate sales price of securities sold under Rule 701 must not exceed the greatest of three amounts^{9, 7}:

Two counting rules matter for option grants. For the ceiling, securities underlying options count on the date of the option grant, not the exercise date⁹. And options are valued on the exercise price, so a low strike price leaves more of the ceiling free⁹.

When the disclosure duty starts

If sales in any consecutive 12-month period exceed $10 million, the issuer must deliver the plan disclosure to investors a reasonable period before the sale, and for a stock option that disclosure goes out a reasonable period before exercise⁹. A growing company should therefore track the 12-month total grant by grant⁹. Rule 701 does not replace the 409A work above. Rule 701 settles whether the grant can be made without registration, and 409A settles what price the grant carries^{7, 8, 9, 10}.