Non-Qualified Stock Option (NSO)

It could be provided to employees as an alternative kind of pay and as a way to reward their commitment to the firm.

Patrick Curtis

Reviewed by

Patrick Curtis

Expertise: Private Equity | Investment Banking


September 27, 2022

Companies often provide one of three basic stock options types as a component of employee compensation packages, which include the following: 

  • Non-qualified stock options (NSOs) 
  • Incentive stock options (ISOs)
  • Restricted stock units (PSUs)

The Internal Revenue Service taxes different types of the mentioned equity differently. NSOs are stock option that does not qualify the employee for favorable tax treatment. 

When one exercise NSOs, unlike incentive stock options (ISOs), one must pay taxes on both the acquisition and the sale of the shares.

Compared to incentive stock options, NSOs are easier to use and more prevalent. However, because they fall short of the Internal Revenue Code's sCode'sds to qualify as ISOs, they are known as non-qualified stock options.

This option allows the employees of a company to buy a set amount of their company at a predetermined price, which expires after a certain amount of time.  

It could be provided to employees as an alternative kind of pay and a way to reward their commitment to the firm.

When the corporation makes such options accessible, also known as the grant date, the price of these stock options is usually the same as the market value of the shares. 

Employees will have a deadline, known as the expiration date, to exercise their options. If the date passes without the employee exercising, the options are forfeited.

It is expected that the company's price will rise over time. This implies that if the grant price (also known as the exercise price) is lower than the following market values, workers may be able to buy shares at a discount. 

When the option is exercised, the employee will pay income tax on the difference between the option price and the market share price of the stock. 

When the options are exercised, the employee can sell or keep the shares immediately.

Non-qualified stock options, like other stock options, can lower the cash compensation corporations give to their employees while simultaneously linking a portion of their remuneration to the companies. 

Employees may be required to wait for the options to vest under the terms of the options. Furthermore, if the employee leaves the firm before the stock options have vested, the options may be forfeited. 

Clawback clauses may also exist, allowing the corporation to retrieve NSOs for several reasons. For example, this might involve the companies or a buyout.

How are NSOs taxed?

Primarily, employees do not get taxed when they are granted an NSO. As mentioned before, this type of stock option obliges the employee to get taxed in both the following circumstances:

1. Exercising the option

The employee will be taxed on the difference between their strike price (set purchase price) and the current market price of the stock options when exercising them. 

When one exercises the stock option, their firm usually holds ordinary income tax (including payroll and regular income taxes).

For instance, if an employee exercises 100 vested options at a grant price of $1 and the current value is $2, they will be taxed on the $100 gain.

2. Selling the acquired shares 

One can sell their stock immediately after exercising their options or keep it. If they sell straight away, they will not incur any capital gains and will be subject to ordinary income tax on the spread.

If they sell your stocks within a year after exercising their options, they will be taxed on any value increase since the exercise date. However, if one retains their stocks for more than a year before selling, they will be subject to long-term capital gains tax, which is usually lower than the short-term capital gains tax rate.

Ordinary income taxes are levied on NSOs depending on the difference between the current fair market value and the option's strike price. However, unlike ISOs, NSO holders must pay taxes withheld when the option is exercised. 

NSOs can make an IRS Section 83(i) choice to postpone taxes for five years.

Types of Stock Options

As mentioned above, there are multiple stock options that companies can choose to provide to their employees. A stock option grants an employee the right to purchase a predetermined number of shares in a firm at a predetermined price, commonly known as the "strike "rice."

When" the firm issues the options, the price is usually set by the fair market value. If the value of those shares rises between the time the options are given and the date the options are exercised, the employee might profit from the difference, often known as "the spec" ad."

The fair market value determines the t"ming of stock options taxes. If the FMV is easily determined, the stock option is taxable when issued. The FMV to be easily determined is for the stock to be traded on public security markets. However, that is not the case with privately owned firms.

The known main types of options that employees get are:

  1. Incentive Stock Options (ISO)
  2. Non-qualified Stock Options (NSO)

Employees with incentive stock options can purchase shares in the firm at a reduced price. In addition, ISOs are eligible for preferential tax treatment if the employee fulfills both of the following requirements:

ISO shares must be kept for at least two years following the grant date and at least one year following the exercise.

Employees who receive the option grant or exercise it are not required to pay taxes. Instead, the employee only reports taxable income when they sell the shares.

When the ISO shares are sold after completing the two conditions, the employee realizes a long-term financial gain on the difference between the sales and strike prices. However, if the standards are not satisfied, the employee's element is regular earned income.

How to use an NSO stock option 

Employees with these options must pay the regular income tax rate on the difference between what they bought for the stock and what it is worth when sold. 

When a corporation gives non-qualified stock options to its workers, the employees are entitled to acquire a set number of shares at a defined price throughout a period determined by the firm.

A corporation may provide non-qualified stock options to its workers for various reasons. First, instead of typical remuneration, NQOs might be provided. Second, the corporation may wish to instill a sense of loyalty in its personnel.

Companies nearly typically utilize the market value of those shares if they were publicly accessible for pricing non-qualified stock options for workers. 

Employees must exercise their options before the specified expiration date after they have been granted, or else be at risk of losing their options.

For example, suppose the corporation provides an employee 10,000 non-qualified stock options with a strike price of $1 per share. Because the stock isn't recently traded on a regulated market, the non-qualified stock option isn't at the time of the award.

When the stock price reaches $5 per share, the employee exercises the non-qualified stock options, paying the business $10,000 ($1 for each option executed). 

The $4 difference between the strike price and the stock price is taxable remuneration for the employee, subject to ordinary income and payroll taxes.

The employee may sell the shares immediately (assuming there is a market to do so). There should be no additional tax; the employee may sell them for $5 per share, which also serves as their basis.

However, if the employee retains the stock for more than 12 months and sells it for $6 per share, they must record a long-term capital gain of $10,000 — their $60,000 sales price less their $50,000 basis.

NSOs vs. RSUs (Restricted Stock Units)

The two have different qualities that make them stand out from each other. They are similar but not identical.

RSUs differ from stock options in requiring no transaction or stock price. Instead, the corporation just agrees to provide an employee with shares in the company if particular criteria are met. 

RSUs can be granted for fulfilling performance goals or staying with the company for a specified period.

If needs are met, the firm will issue RSUs in either actual shares or cash equivalents based on the value of the stock at the time. 

They can choose to give the employee genuine shares or cash equivalents. Alternatively, it may be up to the employee to decide.

RSUs often vest over several years, and it is not uncommon for an employee to get nothing until they have worked for a business for an entire year. 

Following that period, several companies have structured RSUs to vest 1/4 or 1/5 of the total number of RSUs awarded. Then additional RSUs are granted each month the employee continues with the company.


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Researched and authored by Anja Corbolokovic | Linkedin

Reviewed and Edited by Kevin Wang | LinkedIn

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