The core difference
Both give you the right to buy stock at a strike price, but the tax treatment diverges completely. NSOs are taxed as ordinary income on the spread the moment you exercise, with payroll withholding. ISOs trigger no regular tax at exercise, can qualify the entire gain for long-term rates, but expose you to the Alternative Minimum Tax if you exercise and hold.
At exercise
Exercise an NSO and the bargain element (FMV − strike) is immediately ordinary income, subject to income tax plus Social Security and Medicare. Exercise an ISO and there is no regular tax at all — but the same bargain element becomes an AMT preference item if you hold the shares past year-end, which can create a cash tax bill on a paper gain.
At sale
With an NSO, your basis is the FMV at exercise, and only the gain since then is a capital gain (short- or long-term by holding period). With an ISO, a qualifying disposition (held >2 years from grant and >1 year from exercise) taxes the entire gain over the strike at long-term rates — the best possible outcome. Miss the holding periods and the ISO becomes a disqualifying disposition, taxed much like an NSO.
AMT vs FICA
This is the trade-off in one line. NSOs pay FICA (Social Security + Medicare) on the spread but never trigger AMT. ISOs pay no FICA and defer regular tax, but carry AMT risk on exercise-and-hold. For large spreads, the AMT exposure on ISOs can be significant; for small spreads it is often negligible.
Who gets which, and which is better
Employers generally grant ISOs only to employees (with a $100,000/year vesting limit) and use NSOs for contractors, advisors and above the ISO limit. Neither is universally "better." ISOs reward patient holders who can manage AMT and reach a qualifying disposition. NSOs are simpler, predictable, and fine if you plan to exercise and sell without a long hold. Many people hold both and treat each differently.
Side-by-side summary
ISO: no tax at exercise, AMT risk if held, whole gain can be long-term, no FICA, employees only. NSO: ordinary income at exercise, FICA applies, basis steps up to FMV, no AMT, anyone. Run your own numbers in the ISO/AMT and NSO calculators to see the difference on your grant.