Your Offer Letter Has a Section You Probably Glossed Over
“You’ll receive an initial grant of 50,000 ISOs with a four-year vesting schedule and a one-year cliff, subject to board approval.”
That sentence is in roughly half the tech offer letters sent this year. Most people nod, accept the offer, and figure they’ll sort out what ISOs means later. Later usually arrives at tax time, or when the company files for IPO, or — more often — when they give notice and suddenly have 90 days to make a decision involving tens of thousands of dollars.
Let’s not be that person. Here’s what ISOs, NSOs, and RSUs actually are, how each one is taxed, and which type is better for your situation.
The Three Types of Equity Compensation
ISOs: Incentive Stock Options
ISOs are the fancy kind of stock options, reserved exclusively for employees (not contractors, not advisors — employees). The IRS gives them preferential tax treatment as an incentive for you to stay and bet on the company.
Here’s how they work:
- At your grant date, the company sets a strike price equal to the current fair market value of the stock. If shares are worth $2 today, your strike price is $2.
- You don’t pay anything yet. You just have the option to buy shares at $2 in the future.
- When you exercise, you pay the strike price and receive actual shares.
- When you sell those shares, you owe tax on your gain.
The tax treatment is where ISOs shine — and where they get complicated.
No ordinary income tax at exercise. If you exercise ISOs, you don’t owe regular income tax on the spread (the difference between FMV and your strike price). This is the big ISO advantage.
But the spread is an AMT preference item. The spread you skip for regular income tax still gets counted for the Alternative Minimum Tax. If you exercise a large ISO grant when the FMV is much higher than your strike price, you may owe AMT even though you haven’t sold a single share. This is how engineers end up with a six-figure tax bill and stock they can’t sell. It has ended careers. More on this below.
Long-term capital gains if you hold long enough. To get the best possible tax treatment on an ISO, you need to hold for two years from the grant date AND one year from the exercise date. Hit both conditions and your entire gain — from strike price to sale price — is taxed at long-term capital gains rates (0%, 15%, or 20% depending on your income). That’s the ISO dream.
If you sell too soon (before either holding period), it’s a “disqualifying disposition” — the spread at exercise (FMV on exercise date minus your strike price) gets taxed as ordinary income, and any appreciation above that FMV between exercise and sale is a short-term capital gain. You gave up the ISO advantage, but it’s not all ordinary income if the stock kept moving.
The 90-day exercise window. Here’s the clock nobody warns you about. If you leave the company — voluntarily or otherwise — you have 90 days to exercise your vested ISOs before they expire and become worthless. That’s the default rule by law for ISOs. Some companies are more generous (a handful now offer 5-10 year windows), but 90 days is what your grant agreement almost certainly says.
Ninety days sounds like a lot. It isn’t, when you’re jobless, stressed, and suddenly need to come up with real cash to exercise options in a private company with no liquidity.
NSOs: Non-Qualified Stock Options
NSOs work mechanically like ISOs — strike price, exercise, sell — but they lose the preferential ISO tax treatment. In exchange, they’re more flexible: companies can grant NSOs to contractors, advisors, and board members, not just employees.
The tax difference is blunt: the spread at exercise is ordinary income, full stop. When you exercise NSOs and the stock is worth $20/share with a $2 strike price, you owe income tax on $18/share in the year you exercise. This gets added to your W-2.
After exercise, any additional appreciation before you sell is a capital gain (short or long term depending on how long you hold). But the initial spread? That’s just income.
NSOs don’t have the AMT problem ISOs have — ordinary income tax is ordinary income tax. There’s no shadow tax calculation to worry about.
The 90-day exercise window typically applies to NSOs too when granted to employees, though some companies set different terms in the grant agreement. Read yours.
RSUs: Restricted Stock Units
RSUs are the boring, safe, late-stage version of equity compensation — and at many points in your career, boring and safe is exactly what you want.
There’s no strike price. There’s no exercise. You just wait for the shares to vest, and when they do, you own shares. The company withholds taxes via sell-to-cover (they sell some shares to cover your withholding), and the rest land in your brokerage account.
Tax treatment: The fair market value of your shares on the vest date is ordinary income. It goes on your W-2. This happens automatically whether you want it to or not.
After vest, any appreciation is capital gain (short or long term). If your shares were worth $50 when they vested, that’s your cost basis. If you sell at $60 a year later, you owe long-term capital gains on $10/share.
RSUs don’t expire. They don’t require you to pay anything. If the stock has value when they vest, you have value. The only way to lose is if the stock goes to zero.
The AMT Risk With ISOs: A Worked Example
This is the section worth reading twice.
Let’s say you joined a startup in 2022 and received 100,000 ISO options at a $1 strike price. It’s now 2026, the company has done well, and the current FMV is $20/share. You’re leaving to take another job.
You have 90 days. You decide to exercise all 100,000 options.
- You pay: 100,000 × $1 = $100,000 in cash
- You receive: 100,000 shares worth $20/share = $2,000,000 in stock
For regular income tax: $0 owed at exercise (that’s the ISO benefit)
For AMT purposes: the spread ($20 - $1) × 100,000 = $1,900,000 is a preference item. Your AMT calculation might produce a tax bill in the hundreds of thousands — on stock you haven’t sold and can’t sell (it’s a private company).
This is not a hypothetical. It has happened. The 2000 dot-com crash wiped out engineers who exercised ISOs at $20/share, triggered a $400k AMT bill, and watched the stock fall to $0 — leaving them owing taxes on wealth that no longer existed.
The lesson: before exercising a large ISO block in a private company, talk to a CPA. Specifically, run the AMT calculation before you exercise. The ISO tax benefit is real, but it requires the company to actually be worth something when you sell.
Concrete Tax Examples
ISO Example (Best Case — Qualifying Disposition)
- 10,000 ISO shares, strike price $5, current FMV $50
- You exercise: pay $50,000 for shares now worth $500,000
- You hold for 1+ year post-exercise and 2+ years post-grant
- You sell at $60/share ($600,000 total)
Tax owed:
- At exercise: $0 regular income tax (but check AMT — the $450,000 spread is a preference item)
- At sale: ($60 - $5) × 10,000 = $550,000 gain, taxed at long-term capital gains rate
- At 20% LTCG rate: ~$110,000
Compare to ordinary income tax: at a 37% marginal rate on $550,000 = $203,500. The ISO structure saves you $93,500 in that scenario. That’s the prize.
NSO Example
- 10,000 NSO shares, strike price $5, FMV at exercise $50
- You exercise: pay $50,000, get $500,000 in stock
- The spread ($450,000) is added to your W-2 as ordinary income
- You owe income tax immediately — around $166,500 at 37%
- You sell one year later at $60/share
- The additional $10/share gain ($100,000) is long-term capital gains — another $15,000-$20,000
Total tax: roughly $185,000. NSOs are clearly worse than ISOs for the same economics, but at least there’s no AMT surprise.
RSU Example
- 10,000 RSUs vest at $50/share (no strike price, no exercise cost)
- $500,000 added to W-2 as ordinary income in the year of vest
- Tax at vest: ~$185,000 at 37%
- You sell immediately (the mathematically defensible default)
- No additional tax
RSUs look the same as NSOs tax-wise in this example — but you didn’t have to come up with $50,000 to exercise. That matters enormously.
Which Is Better, By Stage
Early-stage startup (pre-Series B, uncertain outcome):
ISOs are potentially fantastic. If you join at $1 FMV, exercise early while the spread is small (low AMT risk), hold for the qualifying period, and the company 10x’s — you pay long-term capital gains on the entire gain. The math is extraordinary. You’re also betting real money on an uncertain outcome, and you need enough cash to exercise without financial pain if the company tanks. ISOs reward patience and financial cushion.
Late-stage private (Series D+, clear IPO path):
The calculus shifts. The FMV is probably $30-80/share by now, and if your strike is $10, the spread you’d trigger at exercise (for AMT purposes, and NSO tax) is meaningful. Companies at this stage often grant NSOs or RSUs instead, because the mechanics of ISOs become painful. If you do have ISOs with a large spread, the exercise decision requires careful tax planning — you might want to exercise in stages to manage AMT exposure.
Public company:
RSUs win, almost without exception. Here’s why: no exercise required, no cash outlay, no AMT calculation, no 90-day window stress when you leave. The shares vest, they’re taxed, they’re in your account. Sell immediately and diversify, or hold if you have a thesis — but you’re never in a situation where you can’t access your equity because you don’t have the cash to exercise.
Public company stock options exist, but they’re relatively rare as the primary equity instrument. If your public employer offers them, they’re probably structured as NSOs, and you’re essentially buying stock at a set price — reasonable if you believe in the company, but RSUs remove the purchase step entirely.
The Practical Checklist
Before you sign an offer or exercise anything:
- Get your grant agreement. Not the offer letter — the actual legal document. It specifies strike price, exercise window (is it 90 days or longer?), and type of options.
- Know the type. ISO vs NSO changes your tax situation significantly. Public companies usually use RSUs or NSOs.
- Run the AMT number before you exercise ISOs. Especially for private company ISOs with a large spread. The IRS has a Form 6251 — a CPA can run this in under an hour.
- Know the 90-day clock. Before you quit, decide what you’re doing with your vested options. Don’t let the clock run out because you were busy with the job search.
- Understand liquidity. Options in a private company are worthless until there’s a liquidity event (IPO, acquisition). You can exercise and hold “real shares,” but you can’t sell them. RSUs in a private company have the same problem.
The Short Answer
If someone asks “which is better” without any context: it depends on what stage company you’re at and what the current spread looks like.
Early startup with a low strike price and a company you believe in? ISOs with a careful exercise strategy can generate life-changing wealth with preferential tax treatment.
Public company or late-stage private with predictable liquidity? RSUs. No games, no expiry clocks, no AMT surprises. Vest, tax, diversify, move on.
The equity compensation that looks the most boring on paper is often the one that actually turns into money you can spend.
