Main Differences
A company grants an employee options with a exercise price of $0.10 per share.
By the time options fully vest, the shares are worth$1.00 each. The employee decides to exercise the option by paying $0.10 for each share.
The $0.90 difference between the fair market value (FMV) and the exercise price of the share, is known as the spread.
For NSO options, the spread is taxed federally as regular income. For ISO options, there are no federal taxes.
On sale of the shares some time later, the shares are taxed at the long-term capital gains rate on:
- NSO: The difference between the value at sale and the FMV at exercise
- ISO: The difference between the value at sale and the exercise price
Further differences and limitations for ISOs are available here.