How the 409A Sets Your Strike Price: ISOs vs NSOs

How this page fits with our other guides: This article covers one question: how the 409A value is applied differently to ISOs and NSOs. How appraisers arrive at the fair market value behind your strike price is covered in how the 409A sets your strike price, and the alternative minimum tax on ISO exercises has its own guide, 409A, early exercise and the AMT trap. We link to those pages rather than repeat them.

What is the difference between ISO and NSO stock options?

An ISO is a stock option that meets the requirements of Internal Revenue Code Section 422. It can be granted only to employees and gets favorable tax treatment: no regular income tax at exercise and possible long-term capital gain on all of the growth. An NSO is any other option. Its spread at exercise is taxed as ordinary income.

The difference is not in the option itself. Both give the holder the right to buy a share of common stock at a fixed price for a fixed period. The difference is whether the grant meets a list of statutory conditions. Under Section 422, an ISO must be granted under a written plan that states the maximum number of shares available as ISOs and that shareholders approve within 12 months before or after the board adopts it. The ISO must be granted within ten years of plan adoption or approval, have a term of no more than ten years, be transferable only at death, and have an exercise price of at least the stock's fair market value on the grant date.

Fail any one of those conditions and the option is simply an NSO for tax purposes. That is why the line between the two types runs straight through the 409A valuation: the fair market value requirement is the condition a company is most likely to miss without knowing it.

Is the strike price the same for ISOs and NSOs?

Usually, yes. Most private companies set the strike price of both ISOs and NSOs at the board-adopted 409A value of common stock on the grant date. The exception is an ISO granted to an employee who owns more than 10% of the voting power, which must be priced at no less than 110% of that value.

The reason the numbers match is that two separate rules arrive at the same floor. For ISOs, Section 422(b)(4) requires an exercise price of at least the fair market value of the stock when the option is granted. For NSOs, there is no ISO statute, but the Section 409A regulations exempt a stock option from 409A only if its exercise price can never be less than the fair market value of the underlying stock on the grant date (Treasury Regulations Section 1.409A-1(b)(5)(i)(A)). An NSO that meets that test is not deferred compensation. An NSO that fails it generally is.

In practice, the same independent 409A appraisal supports both. For Section 409A, an independent appraisal dated no more than 12 months before the grant is presumed reasonable under the 409A safe harbor. For ISOs, the statute and regulations ask whether the company determined fair market value in good faith, and the ISO regulations point to valuations by independent, well-qualified experts as evidence of good faith. A current, independent 409A valuation for ISO and NSO grants is therefore the evidence for both rules at once.

Nothing stops a company from setting a strike price above the 409A value. Premium-priced options are rare at startups because they reduce the value to the employee, but they create no ISO or 409A problem.

ISO vs NSO at a Glance: How the 409A Value Flows Through Each

The table below follows the 409A value from grant to sale for each option type. The rightmost column shows where the valuation itself does the work.

The first two rows are where ISOs and NSOs look alike. The rows after them are where the 409A valuation ISO NSO differences show up, and they are covered in the sections that follow.

The 10% Shareholder Rule: When the ISO Strike Must Be 110% of the 409A

Sections 422(b)(6) and 422(c)(5) add a second floor for employees who, at the time of grant, own stock with more than 10% of the total combined voting power of all classes of stock of the company or its parent or subsidiary. For those employees, an ISO must have an exercise price of at least 110% of fair market value on the grant date, and it must expire no more than five years after grant instead of ten.

At a startup, this rule mostly reaches founders and early executives. Ownership is measured with the attribution rules of Section 424(d), so stock held by a spouse, ancestors, lineal descendants, siblings, or entities the employee owns an interest in can count toward the 10%. Stock the employee could buy under unexercised options is not counted as owned for this test.

A simple example: the board adopts a 409A valuation of $2.00 per share of common. A new engineer receives ISOs at $2.00. A co-founder who holds 18% of the voting power receives ISOs on the same day, which must carry a strike price of at least $2.20 and a term of five years or less. If the company prices the co-founder's grant at $2.00, the option does not meet the ISO requirements and is taxed as an NSO. Because $2.00 still equals the 409A value, the option does remain exempt from Section 409A, since the 110% rule exists only in the ISO statute.

Boards often handle this by granting 10% holders NSOs at 100% of the 409A value instead, accepting ordinary-income treatment in exchange for the lower strike price and the longer term. Either choice works, as long as it is a deliberate one.

The $100,000 ISO Limit Is Measured at the 409A Value

Section 422(d) limits how many options one employee can hold as ISOs. If the aggregate fair market value of the stock under ISOs that first become exercisable for an employee in any calendar year exceeds $100,000, the options over that amount are treated as NSOs. The limit counts ISOs under all plans of the company and its parent and subsidiary corporations, applied in the order the options were granted.

The detail that ties this to the 409A valuation: the fair market value is measured on the grant date, not when the options vest or are exercised. At a private company, that means the grant-date 409A value. The strike price is irrelevant to the calculation; what matters is the number of shares times the 409A value.

• Low 409A, more ISO room. With a 409A value of $0.50, an employee can have 200,000 options first become exercisable in a year and stay within the limit.
• Higher 409A, less room. At a 409A value of $5.00, the same $100,000 covers only 20,000 options per year. A grant of 120,000 options vesting evenly over four years puts 30,000 in each year, so 10,000 per year are NSOs.
• Early-exercise grants are the trap. If the option agreement lets the employee exercise before vesting, every option is exercisable from the grant date. The whole grant then counts in the year of grant, and a large grant can be mostly NSOs even though it vests over four years.

The split is automatic; the company does not need to issue a separate NSO grant. But the company does need to track it, because the ISO portion and the NSO portion are taxed and reported differently at exercise. As the 409A value climbs after each financing, the $100,000 limit catches more of each new grant, which is worth modeling when sizing the option pool and senior hire packages.

What happens if an ISO strike price is below fair market value?

An ISO priced below fair market value on the grant date fails Section 422 and is taxed as an NSO, unless the company made a good-faith attempt to set the price at fair market value. As a discounted NSO, it then generally falls under Section 409A, which can tax the spread as it vests plus a 20% additional tax.

The two steps work like this. First, the ISO rules. Section 422(c)(1) treats the fair market value requirement as met if the company tried in good faith to meet it and fell short. A good-faith attempt is hard to show without a reasonable valuation. A strike price set from an old 409A that no longer reflected value, from a board estimate, or from a value the company knew was stale is the kind of pricing that loses this protection.

Second, the 409A rules. ISOs are exempt from Section 409A as statutory options. Once an option fails to qualify as an ISO, it has to qualify for the NSO exemption instead, and that exemption also requires an exercise price of at least fair market value on the grant date. A discounted option that fails both is generally deferred compensation. Because a typical option can be exercised whenever the holder chooses, it usually cannot meet 409A's rules on when deferred compensation is paid. The result for the option holder, described in our guide to 409A valuation penalties, is that the spread is included in income as the option vests, plus a 20% additional federal tax and a premium interest charge, and the company faces withholding and reporting failures.

Notice that the NSO side of this has no good-faith rule. For an NSO, the question under Section 409A is whether the exercise price was at least fair market value, and the company's protection is a valuation that meets the 409A regulations' reasonableness standard, ideally one that qualifies for a presumption, such as an independent appraisal. Discounted options can sometimes be corrected, typically by raising the exercise price before the option is exercised, but the IRS correction guidance has timing limits and requirements. That is a question for counsel, and the time to ask it is as soon as the problem is found.

How the 409A Value Shapes Tax at Exercise and Sale: ISO vs NSO

The 409A valuation matters a second time when options are exercised. At a private company, the fair market value on the exercise date is normally the 409A value in effect that day, and the spread between that value and the strike price is what each tax regime measures. The two option types treat that spread very differently.

Consider an illustrative employee granted 10,000 options with a $1.50 strike, set by the 409A at grant. Three years later the employee exercises when the 409A value is $6.00, so the spread is $45,000. The company is later acquired at $20.00 per share and the employee sells. The first and third columns assume the sale comes more than a year after exercise (and more than two years after grant); the middle column assumes the acquisition closes later in the same calendar year as the exercise.

Read across the rows and the pattern is clear. With an NSO, the $45,000 spread measured at the 409A value is wages: reported on the employee's W-2, subject to income tax withholding and Social Security and Medicare taxes, and deductible by the company under Section 83(h). The employee's basis becomes $6.00 a share, so only the later growth to $20.00 is capital gain. For a non-employee, such as an advisor, the spread is reported on Form 1099-NEC and is generally subject to self-employment tax.

With an ISO, exercising is not a regular tax event under Section 421(a), and there is no income tax withholding or FICA on the exercise or on a later disqualifying disposition. If the employee holds the shares more than two years from grant and one year from exercise, the full $185,000 gain over the $1.50 strike is long-term capital gain. The cost is the alternative minimum tax: the $45,000 spread is an AMT adjustment in the year of exercise, and the higher the 409A value on that date, the larger it is. Our AMT and early exercise guide works through that calculation.

If the ISO shares are sold before the holding periods end, a disqualifying disposition, the spread at exercise becomes ordinary income in the year of sale, generally limited to the actual gain if the shares are sold for less than the exercise-date value, and the company gets a matching deduction. When the sale falls in the same calendar year as the exercise, there is no AMT adjustment. The company reports ISO exercises on Form 3921, using the 409A value on the exercise date, and NSO income for employees on the W-2 (box 12, code V). The figures above are simplified and ignore state tax and the AMT credit; they are not tax advice.

Choosing Between ISOs and NSOs: What Founders and CFOs Should Weigh

For employees, most startups default to ISOs because of the capital-gain upside. NSOs are the only choice for non-employees, and the better choice in several employee cases. A practical checklist for the 409A strike price ISO vs NSO decision at each grant:

• Confirm the 409A is current on the grant date. No more than 12 months old, and refreshed after any event that may materially change value, such as a priced round or a significant acquisition offer. Our guide to 409A valuations and stock options covers grant timing.
• Check each recipient's voting power. Anyone above 10%, counting attribution, needs a 110% strike and a five-year term for ISOs, or an NSO at 100%.
• Run the $100,000 test at the grant-date 409A value. Especially for large grants, grants with vesting acceleration, and any grant that allows early exercise.
• Use NSOs where ISO status cannot hold. Advisors, consultants and non-employee directors cannot hold ISOs at all, and an employee who exercises more than three months after leaving (one year for disability) loses ISO treatment anyway.
• Document the designation. The board consent and the option agreement should state whether each grant is an ISO or an NSO, the 409A valuation relied on, and its effective date.
• Revisit underwater grants carefully. If a new 409A comes in below existing strike prices, a repricing of underwater options is treated as a new grant for ISO purposes, which restarts the two-year holding period and is tested again against the $100,000 limit at the new grant-date value.

The company's tax position also differs. NSOs give the company a deduction when the holder recognizes income, while ISOs generally do not. For a startup with large net operating losses, that deduction may have little near-term value, which is one reason ISOs remain the default for employees at most venture-backed companies.

The Bottom Line on the 409A Strike Price for ISOs vs NSOs

For the base case, the 409A strike price ISO vs NSO answer is that there is no difference: both are priced at the board-adopted 409A value of common stock on the grant date. The difference is in what rides on that number. For ISOs, the 409A value also sets the 110% floor for 10% owners, measures the $100,000 annual limit, and supports the good-faith pricing that keeps ISO status. For NSOs, it is the line between an exempt option and deferred compensation under Section 409A.

At exercise, the 409A value matters again, setting the spread that is ordinary income for an NSO and an AMT adjustment for an ISO. For founders and CFOs, the protection on every one of these rules is the same: a current, independent 409A valuation adopted before the grant, and a grant record that shows which option type was issued and why.

The examples in this article are illustrative and based on simplified assumptions. This article is general information about Section 409A, Section 422 and the taxation of stock options, not legal, tax or accounting advice. ISO qualification, Section 409A compliance and the tax result of any exercise depend on the specific plan, grant and individual facts; consult your own legal and tax advisors before granting, exercising or correcting stock options.