Why Your Option Grant May Be Split Between ISOs and NQSOs

How ISOs and NQSOs Differ explained that incentive stock options (ISOs) and non-qualified stock options (NQSOs) are the same instrument, taxed differently. The ISO's tax advantage comes with conditions, one of which is a limit on the value of vested options that can qualify as ISOs in a given year. That limit is the reason a grant described as ISOs can turn out to be partly NQSOs, and the reason some grant notices list two share counts instead of one.

Whether your grant is affected depends on its size, your strike price, and how it vests. Many grants fit under the limit entirely. Larger ones, the kind senior executives receive, often don't.

Each calendar year, only the first $100,000 of options that vest that year can be treated as ISOs. That $100,000 is measured at your strike price (the number of options multiplied by the strike price), not by what the options are worth today. Options above that amount still vest on schedule and can still be exercised. They're simply treated as NQSOs. The tax code does this automatically; no one has to make a decision or sign anything.

Three details determine how the limit applies to you:

• It applies in the year your options vest. The tax code's wording is the year options become "exercisable for the first time." For most grants, that means the year they vest. It isn't the year the options were granted, and it isn't the year you exercise them.
• Value is measured at your strike price. The calculation is the number of options multiplied by your strike price, which for an ISO is generally the stock's value on the grant date. (In rare cases, such as a strike price set above that value, the tax code uses the grant-date value instead.) A later rise in the share price doesn't change the calculation.
• Every ISO grant from your employer counts toward the same $100,000, including grants from its parent and subsidiary companies. If two grants vest in the same calendar year, their values are added together, and the earlier grant counts first. ISOs from a former, unrelated employer don't count against it.

Each option counts against the $100,000 in the calendar year it vests, valued at your strike price, whether you exercise it that same year, five years later, or never.

There are two situations where "the year it vests" isn't the whole answer, both because the tax code's actual test is when options can first be exercised:

• Early exercise. Some grants let you exercise before your options vest, sometimes called early exercise. Because the options can be exercised from the start, the entire grant may count in the year it's granted, which can push much more of it over the limit.
• Accelerated vesting. If your vesting speeds up, for example when your company is acquired, every option that accelerates counts in the year it accelerates. Accelerated vesting can pull several years of options into a single calendar year and push much of the grant over the limit, turning options that would have been ISOs into NQSOs at the moment of the deal.

Reading Your Grant Notice: Lessons from Real SEC Filings walks through where the option type appears in real grant documents. The grant notice may show a split in an option grant in one of two ways: separate ISO and NQSO share counts, or a single ISO designation with a sentence noting that anything over $100,000 is treated as NQSOs.

It may also not show a split at all. A grant notice can describe an entire option grant as ISOs even when part of it may end up taxed as NQSOs. That's especially likely with a refresh grant. Whether it crosses the limit depends on tranches from your other grants vesting in the same years, and the notice for your most recent grant doesn't necessarily show or consider those previous grants. Companies usually handle the limit by splitting affected grants and tracking the result as options vest, rather than by sizing grants to stay under it. Your stock plan administrator or equity account is the place to confirm which of your options are which.

Return to the Fathcarr Technologies grant from How Stock Options Work ([LINK: sample grant notice, original grant]): 20,000 options at a $10.00 strike price, granted March 1, 2025, with 5,000 vesting each March 1 from 2026 through 2029. Suppose those options are ISOs.

Fathcarr Original Grant: Value Vesting Each Year (sample)

At $50,000 a year, the grant never comes close to the limit. All 20,000 options can be ISOs. Many grants look like this one, and for them the limit never becomes an issue.

Now take a senior executive who joins Fathcarr in September 2026, after the funding round described in What a 409A Valuation Tells You About Your Pre-IPO Stock Options. You can find the details of this grant in our sample grant notice ([LINK: sample grant notice, new-hire grant]). The 409A valuation in effect then is $14.00, so that becomes the strike price. The new hire receives 48,000 options. Vesting starts on the executive's first day, September 1, 2026, with a one-year cliff vesting period for 25% of the grant, then 3,000 options a quarter for the next three years.

At $14.00 a share, $100,000 covers about 7,142 options a year. Here's how the grant divides:

New-Hire Grant: ISO and NQSO Split by Year (sample)

Assumes the executive holds no other ISOs from Fathcarr. Share counts are rounded to whole shares.

A few things stand out:

• The split happens every year, not just at the cliff. In every year of this schedule, more than $100,000 worth of options vests, measured at the strike price.
• The cliff year is the most affected. The cliff concentrates a quarter of the grant into one date, and a quarterly installment lands in the same calendar year.
• The grant is described as ISOs, but about 40% of it isn't.

Your other grants matter too. Every ISO grant from your employer, including its parent and subsidiary companies, counts toward the same $100,000, and earlier grants count first. ISOs from a former, unrelated employer don't count against it. For executives who receive a new grant every year, this overlap is often how the limit comes into play.

Suppose you hold the original Fathcarr grant ([LINK: sample grant notice, original grant]) and receive a refresh grant ([LINK: sample grant notice, refresh grant]) in September 2026: 20,000 more options at $14.00, vesting 5,000 a year from 2027 through 2030. On its own, the refresh grant puts $70,000 a year against the limit, comfortably under it. But in 2027, 2028, and 2029, your original grant also vests $50,000 a year, and it counts first.

Two Grants, One $100,000 Limit (sample)

Share counts are rounded to whole shares.

The original grant counts first against the limit because it was granted first. You do not get to choose. Therefore, the amount over $100,000 comes entirely out of the refresh grant: $20,000 ÷ $14.00 ≈ 1,429 options a year are taxed as NQSOs. Neither grant would split on its own. Together, they do. In 2030, once the original grant has fully vested, all of the refresh grant's options qualify again.

A split grant is two kinds of options in one grant, and each is taxed its own way, as How ISOs and NQSOs Differ explains. For the NQSO portion, the spread is taxed as ordinary income when you exercise, and your employer applies tax withholding. For the ISO portion, the tax result depends on how long you hold the shares. Hold them at least two years from the grant date and one year from exercise, and the sale is a qualifying disposition: everything above the strike price is taxed as long-term capital gains. Sell sooner, and it's a disqualifying disposition: the spread at exercise is taxed as ordinary income after all, much like an NQSO, but generally without the withholding an NQSO exercise gets, so the tax can come due when you file.

One exercise can leave you holding both kinds of shares: ISO shares that have to be held through both periods to get the better treatment, and NQSO shares that were already taxed when you exercised.

That means knowing which of your options are which matters before you exercise. Exercising 10,000 options can produce a very different tax result depending on how many of them are ISOs. It's worth confirming the split with your stock plan administrator, and talking to a tax advisor, before you exercise.

Determining whether your options qualify as ISOs (eligible for more favorable tax treatment) or are NQSOs (whose spread is taxed as ordinary income when you exercise) can be an important step in your financial planning or year-end tax preparation. The $100,000 limit is a tax code rule, not a company choice. It applies to the value of ISOs that vest in each calendar year, measured at your strike price and counted across all your ISO grants from the same employer.

The application of the limit is automatic. It counts your options in the order they were granted, earliest grant first, until the $100,000 limit is reached. Modest grants usually fit under the limit. Larger grants often don't. After the limit is reached, all remaining options vested in that year are taxed as NQSOs, whether or not your grant notice spells it out. You don't get to choose which grants are considered ISOs.

The split happens on its own, but no one may tell you where it fell. Before you exercise, confirm which of your options are ISOs, since that decides how your gain is taxed.