Nonqualified Stock Options (NSOs): What They Are, How They’re Taxed
Nonqualified stock options face less favorable tax treatment than incentive stock options — here's how they differ.
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What are nonqualified stock options (NSOs)?
An NSO gives you the right (but not the obligation) to purchase a set quantity of company shares at a fixed price during a certain time period. This form of equity compensation doesn’t get the same preferential tax treatment as incentive stock options, or ISOs. You may be taxed twice with NSOs — when you exercise your shares and when you sell them.
Here are other key features of NSOs:
Who’s eligible: Companies can grant NSOs to employees, as well as outside service providers, such as advisors, board directors or other consultants.
No limits: Employers aren’t limited in the number of NSOs they can offer each person. That’s why NSOs sometimes are granted as an extra benefit on top of ISOs, which can lose some or all of their favorable tax treatment if their value exceeds $100,000.
Expiration: You have to exercise your NSOs within a set timeframe.
Stock options could allow you to purchase company shares at a below-market price. The more your company's share price grows, the more valuable your stock options become. This explains why companies use employee stock options as a type of deferred compensation to motivate and retain employees.
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NSOs vs. ISOs
Compare NSOs and ISOs at a glance.
NSOs | ISOs | |
|---|---|---|
Eligibility | Employees, plus outside service providers, such as advisors, board directors, other consultants. | Employees only. |
Tax treatment | No preferential tax treatment. You may owe:
| Preferential tax treatment. That means:
|
Limits | None. | ISOs lose some or all of their preferential tax treatment if the value of the underlying shares exceeds $100,000 per year. |
How NSOs work
NSOs can be broken down into five phases.
Grant date. The grant date is the date on which your employer awards you the stock options. The contract details the amount of shares you have the right (but not the obligation) to buy at a fixed price (called the strike or exercise price) after the vesting period.
Vesting period. The vesting period is the amount of time you need to wait — and stay employed with the company — before gaining the right to exercise your options.
Exercise date. The exercise date is the date on which you purchase company shares. Generally, once your shares vest, you can exercise your options at any point in time up until your options’ expiration date.
Sale date. This is the day on which you sell the shares you acquired by exercising your options.
Expiration date. This is the date on which your options are no longer exerciseable. Options typically expire 10 years after the grant date.
Many factors go into figuring out when to exercise your stock options. As you think through your financial situation and make plans, the tax implications of NSOs will likely factor into your decision-making.
How NSO taxes work
NSOs are generally subject to higher taxes than ISOs because they are taxed on two separate occasions — upon exercise and when you sell the shares — and because ordinary income tax rates are generally higher than long-term capital gains tax rates.
Income tax upon exercise
When you exercise NSOs and opt to purchase company shares, you’ll need to pay ordinary income tax on what’s known as the “bargain element.”
The bargain element is the difference between the market price of the shares and your NSO strike price.
In addition to owing federal and state income taxes, you’ll also be responsible for Medicare and Social Security taxes.
Your employer usually will withhold and remit the taxes to the IRS on your behalf. Your employer may offer you the choice of paying taxes in cash or by reducing the number of company shares you receive to cover the taxes due.
» Looking to minimize income taxes? Charitable giving can reduce your tax burden
Capital gains tax upon sale of stock
Profit you make from selling your shares is subject to capital gains tax.
Short- or long-term capital gains tax rates apply depending how long you hold your company shares post-exercise.
Since long-term capital gains are taxed at a lower rate than short-term capital gains, it may make sense to hold onto your shares for over a year, when possible, so you can qualify for long-term capital gains rates. This can help minimize your overall tax burden since you already have to foot the bill for income taxes.
Paying attention to tax consequences helps when planning what to do with your NSOs. Getting a second opinion from a financial advisor can help ensure you’re thinking through all of the considerations relevant to your unique financial situation.
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