Non-qualified stock options

Lesson in Course: Finance at work (advanced, 6min)

We have non-qualified stock options, but what are they?


What it's about: The different tax liability when NSOs are exercised and sold.

Why it's important: If we received NSOs or had to sell early and disqualify our ISOs, we will see taxes on our W-2

Key takeaway: NSOs are taxed at the income rate on the spread at exercise. The resulting gains from a sale are then taxed at the appropriate capital gains rate.

Companies will offer stock options as equity compensation to attract employees, which can be valuable if we work for the next big company. Companies can offer two types of stock options: incentive stock options (ISOs) and non-qualified stock options (NSOs). NSOs are usually only granted when ISOs are not available. Any employee, contractor, consultant, and board director can receive them. 

What is Non-qualified stock option?

A type of stock option offered by companies as equity compensation that doesn't have any tax benefits.

As a refresher, our stock options are valuable if the current stock price (FMV) is higher than the strike price value of our stock options.

This is a payoff diagram. Read more about them here.

The spread will help us understand the different tax rates owed for an NSO. 


NSO taxes on exercise

NSOs differ from ISOs because NSOs are taxed on exercise. When we exercise an NSO, we pay income taxes on the spread or the difference between the stock price and the strike price. Let's take a look at the chart below.

NSO exercise and sales tax
$1 strike price NSO was exercised when the FMV was at $20

The spread of $19 at the time of exercise is taxed as ordinary income.

When we exercise our NSOs, the spread gets reported to the IRS as income regardless if we are able to sell our shares. The "income" we made will show up on our W-2.

W2 Example

We exercised 1000 shares of NSOs with a strike price of $0.20 when the FMV was $30.

The amount of income reported on our W2: $29.80 x 1000 = $29,800

NSO taxes on the sale

We will pay capital gains when we sell our NSOs. The gains are taxed as long or short-term capital gains depending on the length of time that passed since we exercised.

NSO taxes on the sale
NSO are sold when FMV was at $40

Depending on when we sell the shares, the $20 difference between the sales price and the FMV at exercise can be taxed at either long-term capital gains or short-term capital gains.


When NSOs seems like ISOs

Regularly exercising our NSOs will guarantee a tax bill; however, early exercising can make the taxes we owe seem like ISOs.

Early exercising NSOs can save a lot in taxes

Some companies allow us to early exercise our options, meaning we can exercise all of our shares before they vest. If we exercise early, the stock price and the strike price will probably be the same. Since there isn't a difference, we wouldn't owe any taxes on exercise, and any future value would be taxed as capital gains.

Actionable ideas

Having a plan for exercising our NSOs helps prevent surprise tax bills. The lesson about NSO exercise and sales tax dives deeper into what to expect. Since NSOs have no preferred tax treatment, early exercising is even more important for this type of stock option. We can also read more in the lesson about early exercising.

We should also talk to a tax advisor if we're considering early exercising.


What is Non-qualified stock option ?

A type of stock option offered by companies as equity compensation that doesn't have any tax benefits.