Excerpt from Chapter 1 of VC Experts Encyclopedia of Private Equity & Venture Capital.
The principal advantage  of an ISO is that it postpones tax on the holder’s gain (exercise price versus sales price) until the option stock is sold; the tax on an NSO holder occurs upon exercise, measured by the difference between exercise price and fair value as of that time.  This is a major distinction.  The NSO holder has to come up with her tax money earlier in the process, provoking a potentially unacceptable investment risk unless she can sell immediately after exercise. However, as per SEC Rule 144, she cannot sell publicly; that is, she must either hold for one year or sell at a stiff discount, unless she is able to register her stock for sale.  Indeed, the interaction of the Code and Rule 144 can produce a script Yossarian could appreciate. On exercise, the NSO holder owes tax on the difference between exercise price and “fair market value” calculated without regard to the restriction which will lapse,  that is, the inability to sell publicly for one year. Let us say the trading price of the stock is $10 and the exercise price is $6. Tax is owed on $4 of gain. Mr. Yossarian can sell right away in a private transaction but at a gain of only $2. He has to pay tax on $2 of gain he cannot then realize, forcing him to choose an immediate sale at an economic loss so as to develop a countervailing loss for tax purposes. Alternatively, he can pay his tax and hold the stock one year and sell without a discount, but, Catch-22, the stock may have gone down in price in the interim. He has paid tax on a gain he has not seen and, one year later, he may have an economic loss in the stock because the price falls. Moreover, the deduction for interest on the money he has borrowed has been severely limited.  He gets a tax loss after one year of agony, but, by that time, he may be broke. Further, assuming the NSO is subject to vesting in the form of a right to repurchase at the option price if the executive’s service terminates prior to a specified time, the dilemma is increased when the individual must decide whether to make an I.R.C. § 83(b) election (unless the option price equals the fair market value at the time of the election), since, if he makes the election, he will be taxed on the value of appreciation he will not receive if his service terminates before the shares are vested. Note, however, certain avenues of opportunity, when the issuer goes public, it often will maintain an evergreen registration statement on Form S-8, registering shares issued upon the exercise of employee options. If the options become liquid by reason of the issuer merging into a public company for public stock, that stock can be registered under Form S-4.
There is more, however, to the comparison between ISOs and NSOs. The second major advantage of the ISO over the NSO-that the gain on sale was capital gain if the stock is held for a year after exercise (and the sale succeeded the grant by two years)-was rendered relatively immaterial by the 1986 Tax Reform Act (since the differences in tax rates became relatively small to the point of triviality). However, with the 1993 Deficit Reduction Act,  the distinction has been significantly restored and ISOs are back in fashion. Moreover, if the option stock is “qualified small business stock,” it may be that the spread will be even more dramatic.  On the other hand, exercise of an ISO  produces tax preference  in an amount equal to the difference between the “fair market value” of the stock on exercise and the amount paid unless the option stock is sold in the year of exercise-an event which voids preferential treatment under § 422.  This feature led some commentators to forecast the death of ISOs.  The alternative minimum tax (AMT) result is not an unmitigated disaster since, in most instances, the excess tax paid is recovered when and if the option stock is subsequently sold at a gain.  Finally, under the 1993 Deficit Reduction Act, the spread on NSOs will enter into the calculation of executive compensation for purposes of measuring whether the $1 million threshold has been achieved and, thus, deductibility disallowed. The short of the matter is that, in an era in which the tax law changes annually, there is considerable luster to what might be called the “wait and see” approach. According to that strategy, the issuer constructs a plan involving ISOs. Then, as some critical date nears-an IPO looms, for example-the employee enjoys alternatives. She can exercise the option and hold the shares if alternative minimum tax is not a problem as a practical matter, thereby postponing tax while the Rule 144 period runs, or she can do something to disqualify the option as an ISO-sell before the one-year holding period lapses, for example. 
In this connection, the situation must be addressed from the issuer‘s point of view as well. A corporation is not allowed a deduction at any time in connection with ISOs granted to its employees (unless there is a disqualifying disposition of the ISO).  A company can deduct the amount of ordinary income an employee is deemed to have received in connection with an NSO at the same time ordinary income is includable in the employee’s taxable income. The value of the deduction allowed to a profitable corporation in connection with an NSO may well exceed the value to the executive of an ISO over an NSO. Perhaps the issuer will want a tax deduction and would be willing to pay the employee a bonus, accordingly, to make a disqualifying disposition. Moreover, in the event of a disqualifying disposition, the gain is the lesser of the putative gain on exercise or the actual gain on sale.  [Also, as indicated, the accounting treatment of NSOs and ISOs is the same; a “hit” to earnings only if the option is granted at less than fair value,  ] or unless the issuer elects … see Accounting for Options Generally, § 7.01(i) infra.
The point is that there is no one “right” answer to the ISO/NSO decision, particularly in view of the uncertainty posed by the FASB proposals and the irresistible impulse of politicians to tinker with the Internal Revenue Code; it is impossible to set out any general rules. The ISO versus NSO question should be examined carefully in light of the facts of each case and the tax, securities, and accounting rules in effect at that time.
[Note: One (not the only) advantage of NSOs, the ability to set the exercise price below fair market value, is now, history.]
 Newco‘s alternatives are not “either/or.” A qualified ISO plan can be combined with an NSO plan.
 The tax is owed under I.R.C. § 83(a), on the receipt of “property” (i.e., the option stock) in connection with services.
 The ability to time one’s disposition of the underlying shares has “cash value,” even though that value is difficult to quantify in advance.
 Rule 144 omits options from the situations in which the “tacking” of holding periods is permissible. Compare Rule 144(d)(1) and (3).
 The restriction on the ability to transfer by itself does not, despite the language of I.R.C. § 83, impose a restraint which allows the holder to postpone tax under I.R.C. § 83(b). Compare Robinson v. Commissioner, 805 F.2d 38 (1 st Cir. 1986).
 I.R.C. § 163(d). Under the statute prior to the Tax Reform Act of 1986, the individual’s annual maximum deduction for interest on debt to “purchase or carry property held for investment,” I.R.C. §§ 163(d)(1)(A), (B), was net investment income plus $10,000; after the phaseout, it is solely net investment income. I.R.C. § 163(d)(1).
 The spread depends on the adjusted gross income of the taxpayer but it may be subject to AMT effects. I.R.C. § 56(b)(3).
 See discussion of new I.R.C. § 1202, which excludes one-half the gain on the sale of such stock if held for 5 years. See Note on Qualified Small Business (“QSB”) Stock and Rollovers Sections 1202 and 1045.
 The alternative minimum tax puzzle has been well summarized by the author’s then-partner (now an officer of Fidelity Corp.) John Kimpel, in these words:
The employee’s exposure to the alternative minimum tax on the exercise of an ISO can create serious problems. Consider the following nightmare: Company X grants an ISO to a key employee to purchase 100,000 shares of its stock at $.60 a share, its then fair market value (total exercise price $60,000). Four years later … the company goes public at $10 a share. The employee exercises his option and acquires 100,000 shares of stock for $60,000. The amount of the tax preference item potentially subject to alternative minimum tax is $940,000 ($1 million -$60,000). Since the alternative minimum tax is the excess, if any of (a) 20% [now 24% for individuals] of the amount by which taxpayer’s adjusted gross income plus items of tax preference less certain itemized deductions exceeds an exemption amount of $30,000 ($40,000, subject post ’86 to certain reductions, if a joint return if filed), over (b) the regular income tax paid, the employee in the example above may face a staggering tax bill without having sufficient funds to pay the tax.
Kimpel at 53.
 Alternative minimum tax calculations involve comparing the tax calculated at standard rates without regard to AMTI-$ 100,000 say, on $400,000 of income-with the tax which would be assessed were all income, including tax preference items, to form the base amount times the AMT rate-i.e., 24% for individuals.
 If the optionee “disposes” of the stock received pursuant to the exercise of an ISO in the year in which she exercised the ISO, she will not be required to add the spread to his AMTL Treas. Reg. § 1.57-1(f)(5). Generally, an optionee will be considered to have disposed of the stock if she recognizes gain upon such disposition. See I.R.C. § 425(c).
 The Tax Reform Act: What to Do About Stock Options” XI Corporate Counsel I (Sept.-Oct. 1986).
 If the exercise of an ISO results in an AMT liability, the optionee will, to the extent not limited by I.R.C. § 53(c), be entitled to claim a credit (the “AMT credit”) against his regular tax liability in the succeeding taxable year or years equal to the AMT paid. I.R.C. § 53(a). I.R.C. § 56(c) limits the AMT credit, in any given year, to the excess of a taxpayer’s regular tax liability over his AMT liability for that year.
 A disqualifying disposition may, however, itself raise tax issues, if, for example, the stock received upon a disqualifying disposition is subject to a substantial risk of forfeiture. Kimpel at 56-57.
 In order for the employer to take the deduction for compensation expense allowed upon a disqualifying disposition, the employer must withhold tax from the income received by the ISO upon the disqualifying disposition. In fact, the employer must deduct and withhold an appropriate amount of income tax from any wages recognized by the employee upon exercise of the NSO. The employer must also deduct and withhold the employee’s 7.65% portion of FICA taxes from such wages (although no withholding is necessary for the Social Security portion of such FICA taxes to the extent that the employee’s wages have exceeded the relevant Social Security Act contribution and benefit base limit for the current year). The employer is responsible for reporting the withheld amounts on an IRS Form 941, as well as reporting the spread as wages in Boxes 1, 3 and 5 of the IRS Form W-2. Note that if the employer timely prepares and delivers an IRS Form W-2, the employee will be deemed to have included the amount of the spread in his or her gross income such that the employer is entitled to a corresponding business expense deduction.
 I.R.C. § 422(c)(2). Exercise and sale within six months may pose problems for directors, officers, and 10% stockholders under § 16(b) of the ’34 Act. In order to mitigate that result, the plan (ISO or NSO) should be drafted pursuant to the provisions of Rule 16b-3.
 Aufmuth, Selected Tax Accounting Issues in Early and Mezzanine Financings and Venture Capital Partnerships, inVenture Capital After the Tax Reform Act of 1986, at 55, 76 (PLI Course Handbook Series No.422, 1987) [hereinafter Aufmuth].