Strike Price and Fair Market Value: How the Spread Sets Your Tax

A strike price is the fixed dollar amount you pay to buy one share under your option grant. Fair market value is what that share is worth right now. The gap between the two, called the spread, is what triggers your tax bill when you exercise, and it grows every time the company's valuation climbs.

What sets your strike price at grant

The strike price (also called the exercise price) is the price per share you agree to pay when your option grant is signed. For a private company, that number comes from a 409A valuation, an independent appraisal the company commissions to set the current fair value of its common stock.

The IRS requires the strike price to sit at or above the 409A value at grant. If a company priced options below fair value, employees would receive options already worth more than they cost, which the tax code treats as deferred compensation with its own penalties. Setting the strike at the 409A number keeps a fresh grant at zero built-in value. You aren't handed a gain on day one; you earn one only if the company's value rises after your grant date.

Companies refresh their 409A valuation roughly every twelve months, or sooner after a priced funding round. Every new valuation resets the strike price for grants issued after that date, but it does not touch the strike price on options you already hold. Your strike is locked in at grant and stays there until you exercise or the option expires.

Fair market value at exercise and at sale

Fair market value is the second number in the equation, and it moves. At a private company, FMV is set by the most recent 409A valuation in effect on the day you exercise. At a public company, FMV is the trading price of the stock at that moment.

FMV also matters again at sale. Once you own the shares, the sale price determines your capital gain or loss, measured against your cost basis rather than your strike price directly. That second FMV, the one on the day you sell, is a separate event from the FMV on the day you exercised, and the two can differ by years and by a wide margin in valuation.

The distinction matters because two different transactions, exercise and sale, each compare your basis against a different market snapshot. Confusing the two is a common source of tax surprises for people exercising options for the first time.

The spread is the number that drives your tax bill

Subtract your strike price from FMV at exercise and you get the spread, also called the bargain element. This is the actual dollar amount the tax code cares about. It represents the value you received for less than it was worth, and every dollar of it eventually shows up on a tax form in one shape or another.

Here is a way to picture it. Your strike price works like a locked-in price on a layaway purchase you arranged months or years ago. Fair market value is today's price tag on that same item at the store. The difference between what you locked in and what it sells for today is the spread, and it exists whether or not you've decided to buy the item yet.

Meet Sana, an engineer at a fictional logistics startup called Lumen Freight. Her option grant carries a $2 strike price. The company's latest 409A valuation puts FMV at $18 per share. If Sana exercises today, her spread is $16 per share; on a grant of 5,000 shares, that's $80,000 of bargain element showing up in the tax calculation the moment she exercises.

A larger spread pushes an ISO exercise further into AMT territory, because the entire spread becomes AMT income in the year you exercise. Sana's $80,000 spread might sit under her AMT exemption in a light income year, or it might tip her straight into the phaseout band in a year when her salary and the spread combine. The size of the spread is the single biggest lever she controls, since she chooses how many shares to exercise and when.

ISOs and NSOs tax the same spread differently

The spread is identical for both option types on the same grant terms, but the tax code treats it on two completely different tracks.

For an incentive stock option, the spread at exercise is not counted as regular taxable income. Instead, it becomes an AMT preference item, added back into a parallel tax calculation that runs alongside your regular return. You owe no ordinary tax on the spread at exercise, but you may owe AMT, and the size of that bill scales directly with how wide the spread has grown. Our breakdown of the ISO exercise decision walks through how AMT, cash, and concentration risk interact once you're weighing an exercise.

For a nonqualified stock option, the spread at exercise is ordinary income, full stop. It lands on your W-2 in the year you exercise, your employer withholds against it the same way it withholds against salary, and there's no AMT detour to navigate. The tradeoff for that simplicity is timing: you owe tax the moment you exercise, in cash, regardless of whether the shares are liquid.

This is an estimate only. Consult a qualified tax or financial advisor for personalized advice.

Neither structure is universally better. NSOs settle the bill immediately and predictably. ISOs defer ordinary tax entirely and open the door to long-term capital gains treatment on a qualifying disposition, at the cost of an AMT calculation you have to plan around. Our ISO and NSO guides cover the full mechanics of each, and NSO exercise timing digs into when to pull the trigger on a nonqualified grant.

Why a rising 409A widens the gap over time

Your strike price is frozen the day your grant is signed. Fair market value is not. Every new 409A valuation that comes in higher than the last one widens the spread on the exact same options, without you doing anything at all.

This is why waiting to exercise carries a real cost for ISO holders, even when there's no rush to raise cash. A grant with a $2 strike and a $6 FMV has a $4 spread today. If the next funding round pushes the 409A to $18, that same $2 strike now sits under an $16 spread, and the AMT exposure on a full exercise has roughly quadrupled without a single new share being granted. Employees who exercise early, while the strike and the FMV are close together, lock in a small spread. Employees who wait until the company is close to an IPO often face a spread many times larger on the identical grant.

Our breakdown of how the 2026 AMT rules changed covers how a wider spread interacts with a tighter phaseout band this year specifically, which makes the timing question sharper than it was in prior years.

RSUs skip the strike price entirely

Restricted stock units work on a different mechanism altogether. An RSU carries no strike price and requires no purchase. You're granted the right to receive shares outright, and when they vest, the full fair market value of each share on the vesting date counts as ordinary income, taxed and withheld like salary in that instant.

There's no spread to calculate because there was never a discounted purchase price to compare against. The full share value counts as income at vest. That makes RSUs simpler to model than options, but it also removes the ability to control tax timing the way an option holder can by choosing when to exercise. Our RSU guide covers vesting mechanics and withholding in full.

Common questions

Last updated: July 2026. This is an estimate only. Consult a qualified tax or financial advisor for personalized advice.