Takeaways
- NSOs are taxed both when you exercise your options and when you sell them.
- NSOs can be granted to employees, consultants, and the board of directors.
- NSOs are a non-cash way startups pay early-stage employees to preserve cash.
- NSOs align employee compensation with company performance and growth.
- NSOs face harsher tax treatment than ISOs, which are only offered to employees.
Stock options are a common form of equity compensation that companies use to attract, retain, and incentivize employees. Non-Qualified Stock Options (NSOs) are a popular type of stock option. Unlike Incentive Stock Options (ISOs), NSOs do not qualify for special tax treatment, but they offer flexibility and work for a broader group of recipients.
What Is a Non-Qualified Stock Option (NSO)?
A Non-Qualified Stock Option (NSO) is an employer-granted stock option that allows employees, consultants, or board members to purchase common stock at a predetermined price. NSOs do not have to meet specific IRS requirements and are subject to regular ordinary income tax when exercised.
NSO contracts allow you to buy stock at a fixed price, known as the exercise or strike price. If the company's stock price rises above the exercise price, you can profit by purchasing shares at the lower strike price and selling them at the higher market price.
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How Non-Qualified Stock Options Work
A company grants NSOs to employees, specifying the exact number of shares and the exercise price. These options typically come with a vesting schedule, requiring you to remain with the company for a certain period before they can exercise their options.
Vesting schedules can range in length and structure. An example of how a vesting schedule might work is a plan in which 25% of your options vest after your first year with the company and monthly thereafter.
Once your options vest, you can purchase shares at the listed exercise price. If the stock price rises above the exercise price, you can sell the shares to make a short-term or long-term capital gain.
NSOs increase in value the more your company's stock prices exceed your exercise price. They are deferred compensation that incentivizes you to work through your vesting periods and contribute to the company's growth.
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Tax Implications of NSOs
One of the most significant differences between NSOs and ISOs is taxation. NSOs do not receive the same favorable tax treatment as ISOs and are taxed twice.
The first tax is assessed at the time of exercise. The difference between the stock's fair market value on the exercise date and the exercise price is considered income.[1] It is subject to federal and state income taxes and payroll taxes such as Social Security and Medicare. Exercising NSOs could increase your tax rate and bracket. Your earnings from NSOs are included on your Form W-2.
The following tax occurs when you sell your stock: Any additional gain or loss is taxed as capital gains. If the shares are sold within one year of exercise, they are subject to short-term capital gains tax, which is equal to ordinary income tax rates. Keeping the shares for over a year qualifies you for lower long-term capital gains tax rates, which are more favorable. Because NSOs generate taxable income at the time of exercise, you need to plan accordingly to manage your tax liabilities.
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When to Exercise NSOs
When deciding whether to exercise your options, you should consider your company's stock price performance. If you expect the common stock price to rise, exercising your options early can lock in a lower purchase price, and you can sell for a gain.
Tax considerations should be a substantial concern, as exercising NSOs triggers ordinary income tax—you should plan for potential tax obligations. You need enough funds to cover the exercise cost and associated taxes.
If you are considering exercising your options, you might want to opt for a cashless exercise. In a cashless exercise, you sell a portion of your shares immediately to cover the exercise costs and fees, which reduces any financial strain or cash outlay.
Private companies also issue NSOs, but if you work for a private company, you should consider your ability to sell shares before exercising. Private company shares are highly illiquid. Most employees don't exercise their options unless they work for a publicly traded company or private company about to become public through an Initial Public Offering.
Why Companies Offer Options
Companies offer NSOs as part of their compensation strategy for several reasons. They help attract and retain top talent by giving employees potential financial rewards for company performance.
NSOs directly align employees' interests with those of their shareholders. Employees benefit when the stock price increases, motivating them to contribute to company growth and keeping employees loyal. Offering stock options preserves the companies' cash flow, compensating employees without handing out cash.
Pros of NSOs
- Broad Eligibility: NSOs can be granted to employees, contractors, or board members. (Read more about 10 Popular Freelance Jobs).
- No Alternative Minimum Tax (AMT) Considerations: NSOs do not trigger AMT, simplifying tax planning. (Read about the Best Online Tax Software Programs).
- Potential for High Returns: NSOs can lead to significant financial gains if the company's stock price increases. Taking gains off the table can supply you with a stash of cash to save in a high-yield savings account, invest in stocks, or pay off debt. (Plug and Play with our Net Worth Calculator).
- Flexibility in Tax Timing: Employees can choose when to exercise NSOs based on their financial and tax situation. You should create a tax strategy aligned with your vesting schedule. (Read more about How to Choose Your Tax Filing Status).
Cons of NSOs
- Immediate Tax Liability at Exercise: You owe ordinary income tax on the difference between the exercise price and the stock's fair market value when you exercise your NSOs, which can be costly. This can mainly be an issue if you don’t sell your shares to lock in your financial gains.
- Stock Price Volatility Risk: You may owe taxes on gains you never realize if the stock price drops after exercise. If this happens, you can use your losses to offset stock gains for tax purposes. (Read more about Tax-Loss Harvesting).
- Liquidity Challenges: During tax season, you might need to come up with cash to pay your tax liability on exercised shares before you sell them, or you might need to tap into your slush fund to pay your taxes.
- Higher Tax Rates: NSOs are taxed as ordinary income at exercise, which is typically higher than long-term capital gains rates. (Read about the 2025 Federal Income Tax Rates and Brackets).
Smart Summary
Non-qualified Stock Options are employer-granted stock options that allow you to purchase stock at a set exercise price. They are a valuable equity compensation tool companies use to incentivize employees, align their interests with shareholders, and attract top talent. NSOs offer flexibility but also have significant tax considerations. You should carefully plan your exercise strategy to maximize your NSOs while managing their tax impact.
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Frequently Asked Questions
You are granted equity awards when you start a new job or during your annual compensation review cycle. You can be awarded NSOs, ISOs, or Restricted Stock Units (or a combination) based on your title and level within the company.
No, you can choose whether to exercise NSOs or ISOs. This exercise flexibility allows you to plan your taxes. Exercising your NSOs has tax implications and can increase your tax liability.
The most conservative approach to selling stock options is to exercise them and sell them immediately when the fair market value (FMV) of your common stock is above the exercise price. You can also time your exercises and only exercise when your options are “in the money” or when the FMV exceeds your exercise price.
(1) Internal Revenue Service. Taxable and Nontaxable Income. Last Accessed March 11, 2025.
