Which statement correctly contrasts non-qualified stock options with incentive stock options?

• A. NQSOs are taxed as ordinary income on exercise; ISOs may qualify for capital gains if holding periods are met.
• B. NQSOs are exempt from taxes; ISOs taxed at grant.
• C. NQSOs generate AMT adjustments; ISOs do not.
• D. Both are always taxed as capital gains.

Answer: (A)

Tax treatment at exercise versus disposition is what this question tests. Non-qualified stock options cause ordinary income to be recognized in the year you exercise, equal to the spread between the fair market value at exercise and the exercise price, and that amount is included in your W-2 wages (with payroll taxes due). Incentive stock options generally don’t generate regular income tax at exercise, but the spread creates an AMT adjustment; the big tax advantage comes when you sell the shares in a qualifying disposition, meeting holding period requirements (more than one year from exercise and more than two years from grant), in which case the sale proceeds beyond the exercise price are taxed at long-term capital gains rates. If you don’t meet the holding periods, you can incur ordinary income tax on the disposition portion as well.

Other statements don’t fit this contrast: non-qualified options are not exempt from taxes; ISOs aren’t taxed at grant for regular tax purposes (and AMT can apply at exercise); and it’s not true that both types are always taxed as capital gains.