What are non-qualified stock options (NSOs)?

Non-qualified stock options (NSOs) are a type of equity compensation that companies can grant to employees, contractors, consultants, and other service providers. 

Generally, the recipient of an NSO must pay ordinary income tax when they exercise their option. After that, when the shares are sold, any appreciation in the stock price is taxed as a capital gain.

Qualifying vs non-qualifying stock options (NQSO)

There are two key differences between qualifying (QSOs) and non-qualifying stock options (NQSO). 

First, QSOs issued by a company can only be given to employees of that company. They are non-transferable and have an exercise price that is higher than or equal to the fair market value (FMV) of the stock when the option is granted. In contrast, an NSO can be given to anyone. 

The second important differentiator is that NSOs do not qualify for special tax benefits for the recipient, whereas QSOs do. QSOs are not reportable as taxable income to the employee either at the time of grant or when the option is exercised. 

Non-qualified stock options (NSOs) vs incentive stock options (ISOs)

The two main types of stock options that companies grant to employees and service providers are non-qualified stock options and incentive stock options (ISOs). The primary difference lies in their tax treatment and eligibility requirements. Companies often grant a mix of these two based on their compensation strategy and objectives.

Here are the main differences between the two:

• As stated above, NSOs generally do not qualify for any special tax benefits: when exercised, the "spread" is taxed as ordinary income. (The spread is the difference between the FMV of the shares and the exercise price.) NSOs can be granted flexibly without vesting limits. 

• In contrast, ISOs (also known as QSOs) usually receive favorable tax treatment, if strict requirements are met. When ISOs are exercised no income is taxed. If the shares are held for over a year after exercise then they are taxed as long-term capital gains. 

• Another difference is that ISOs can only be granted to employees (not contractors), have a $100,000 annual vesting limit, and must be exercised within set timeframes after employment ends.

In summary, NSOs are more flexible but taxed as ordinary income upon exercise, while ISOs provide potential tax benefits for employees if various requirements are satisfied. 

Compensation element meaning

A compensation element refers to a specific component or part of an overall compensation package offered to employees by an organization. 

Let’s review some of the main compensation elements:

• Salary/base pay: The fixed amount an employee earns.
• Variable pay: Incentives like bonuses and commissions that fluctuate based on performance.
• Benefits: Health insurance, retirement plans, paid time off, and other non-cash benefits.
• Perquisites/allowances: Additional compensation like a company car, club membership, and education assistance. 
• Equity compensation: Includes stock options and restricted stock units that allow an employee to purchase a share in the startup or company’s equity. 

The lifecycle of non-qualified stock options (NSOs)

Let’s take a further look at what happens to an NSO over the course of its life.

1. Grant

The company awards the employee stock options at a predetermined exercise price, also known as the grant price or strike price, which is typically set as the FMV of the company's stock on the grant date. 

At this time, the employee has the right to purchase a set number of shares at the exercise price within a fixed period — and that’s dependent on a vesting schedule determined by the company, which is discussed in more detail later on — and does not have to pay anything. No taxes are due.

2. Vesting

The recipient must meet certain requirements, such as performance milestones or a period of time,  set by the company before being able to exercise the option to purchase the shares. 

During vesting, the employee cannot exercise the options, but is instead gradually earning the right to do so over time. Any options that have not vested by the time of employment termination are typically forfeited by the employee. (We’ll review examples further on.)

3. Exercise

The recipient pays the predetermined exercise price to purchase the shares, converting the stock options into actual shares of company stock. 

This can be done through different methods, which will be explained later; the key point here is that it allows the recipient to become a shareholder. The difference between the exercise price and the current FMV of the shares at the time of exercise is taxed as ordinary income.

4. Taxation

There are different tax treatments depending on the chosen exercise method. We’ll get into this later, but in brief the treatments generally are:

• Options exercised, shares held: The difference between the FMV at exercise and the grant price is taxed as ordinary income.
• Options exercised, shares sold within a year: Any gain above the FMV at exercise is taxed as short-term capital gain.
• Options exercised, shares sold after a year: Any gain above the FMV at exercise is taxed as long-term capital gain.
• Cashless exercise or sell-to-cover: The difference between FMV and grant price (also known as “the spread”) is still taxed as ordinary income, with potential capital gains on any further share price appreciation.  

5. Tracking

The recipient monitors their vested and unvested options in addition to any shares acquired from previously exercised options using an equity management platform or stock plan account. Tracking enables the recipient to stay informed about their equity holdings, vesting status, and is beneficial for tax purposes (e.g. to show to a tax professional for tax advice on potential tax deductions).

Timelines for exercising non-qualified stock options

How do you know when to exercise an NSO? 

Let’s dive in. 

Vesting schedules

Vesting schedules determine the time period or performance milestones an employee must meet before being able to exercise their stock options. They play a crucial role when it comes to exercising NSOs and incentivize employees to remain with the company long-term, as any unvested options are forfeited if the employment is terminated. 

Here’s an example: 

• An employee is given 10,000 NSOs with a 4-year vesting schedule and a 1-year cliff, which is a typical example of a graded schedule. 
• In the first year, no options would vest (the cliff), and the employee could exercise none of the options.
• After the first year, 25%, or 2,500,  of the options would vest. 
• The remaining 75% would vest monthly or quarterly over the next three years until fully vested. As such, monitoring vesting dates is crucial to maximize the value of NSOs.

As an aside, restricted stock units (RSUs) — which, like NSOs, are a form of equity compensation that companies use to reward employees — are taxed highly primarily because they are treated as ordinary income at the time of vesting. RSUs can significantly increase the recipient’s taxable income and potentially push them over the Alternative Minimum Tax (AMT) exemption threshold.

Post-termination exercise period (PTEP)

The post-termination exercise period (PTEP) refers to the window of time the recipient has to exercise their vested NSOs before they expire and become worthless. During this period, the former employee can choose to exercise their option to purchase the underlying shares at the exercise price. Any vested but unexercised NSOs are permanently forfeited after the PTEP. 

The standard PTEP is 90 days from the termination date. 

This short time period can create challenges, especially if the NSOs have an exercise price significantly below the company’s current share valuation. The former employee may not have the funds available to exercise their vested options before they expire. As a result,  some companies have started granting PTEPs of 6 months to a year to grant former employees more flexibility.

The best time to exercise NSOs

There is no single "best" time to exercise NSOs, as it depends on a variety of factors. 

However, from a personal finance and tax-efficient perspective, the ideal time to exercise is often when the spread is at its maximum but before a potential exit event. This may allow for the lowest possible tax rate on the spread while still capturing the maximum appreciation in the company's shares. 

However, picking such an exercise date requires an accurate prediction of the exit event, such as an IPO, which is inherently difficult. So, when determining when the best time to exercise NSOs, make sure to speak with a tax professional or other professional advisor.

How to exercise non-qualified stock options

There are three methods to exercise NSOs: exercise and hold, exercise and sell, and sell to cover.

Let’s explore them. 

Exercise and hold

This method involves exercising the options and then holding those shares during, what’s called a “holding period,” rather than selling them immediately. The recipient pays the exercise price in cash as well as the taxes due on the spread; in return, the recipient gets the full number of shares and can benefit from any potential future appreciation in the price of the stock.

This method is often used when the recipient is optimistic about the company's prospects and wants to capture the full upside by retaining the shares long-term. However, it requires having sufficient cash to cover the exercise costs and taxes upfront.

Exercise and sell (same-day sale or cashless exercise)

This method involves exercising the option and then immediately selling all or a portion of the acquired shares. 

This is often used when the recipient wants to capture the immediate value of their vested NSOs and diversify away from concentrated company stock holdings. They will pay taxes due on the spread as ordinary income, but avoid potential future upside or downside from holding the shares long-term. 

The cashless version is convenient if the recipient lacks funds to cover the full exercise cost. There are two approaches to the exercise and sell method:

1. Same-day sale: The NSOs are exercised and all the shares are sold on the same day. The proceeds from the sale are used to cover the exercise cost and taxes due on the spread, while any remaining cash is the original recipient’s to keep.

2. Cashless exercise: The NSOs are exercised, and just enough of the shares are sold to cover the exercise cost and taxes. The remaining shares are then transferred to a brokerage account, allowing the recipient to exercise without paying cash upfront.

Sell to cover

This method involves selling just enough shares to cover the exercise cost and taxes, while retaining the remaining shares. 

The recipient’s broker will sell a portion of the shares acquired from exercising at the current market price. The proceeds from this share sale are used to cover three components: the exercise cost to purchase the shares at the grant price, the income taxes due on the spread, and any broker fees or commissions. 

After covering these costs, the recipient receives the remaining shares in their brokerage account. This allows them to exercise their NSOs without paying the full exercise cost out-of-pocket, while still retaining some of the shares for potential future upside.

How are non-qualified stock options taxed?

When NSOs are exercised, they are taxed as ordinary income, and subsequent gains when the shares are sold are taxed as a capital gain. 

Let’s look into the taxation of NSOs in more detail. 

At exercise

When NSOs are exercised, the spread is taxed as ordinary income tax withholding, like Social Security and Medicare. The taxable amount is reported as wages on the employee's W-2 in the year of exercise. 

At sale

Any subsequent gain when the shares are sold is treated as a capital gain, calculated as the sale price minus the FMV at the time the NSOs were exercised. 

If the shares were held for less than a year, it’s considered short-term capital gain and taxed at ordinary income tax rates. If they were held for over a year, they receive preferential long-term capital gains rates tax treatment.

The qualified small business stock exception

The qualified small business stock (QSBS) exception is a tax benefit that potentially allows investors to rule out a portion of their capital gains from federal taxes when selling QSBS that meets certain criteria.

Shares acquired through the exercise of NSOs can potentially qualify for the QSBS exclusion if the company meets the definition of a qualified small business under IRS guidance and the Internal Revenue Code. 

This includes requirements including but not limited to being a c-corporation, having gross assets under $50 million when the shares were issued, and operating in an eligible trade or business. If the exercised NSO shares meet the QSBS criteria and are held for at least 5 years before being sold, the recipient may be able to exclude up to $10 million (or 10x their cost basis) of the capital gain from federal taxes.

Are non-qualified stock options taxed twice?

Yes, NSOs are effectively taxed twice: once when they’re exercised as ordinary income, and once when they’re sold as capital gain. 

Are employers required to withhold payroll taxes from NSOs?

Yes, employers generally are required to withhold payroll taxes such as Social Security and Medicare when employees exercise NSOs because the spread is considered to be supplemental wages. 

More specifically, the employer must withhold the employee's portion of Social Security and Medicare taxes on the spread, in addition to withholding federal income tax. Proper withholding and reporting of payroll taxes on NSO exercises is an important compliance requirement for companies.

How to report non-qualified stock options on your taxes (examples)

When you exercise NSOs, the spread is generally considered compensation income and must be reported as tax liability, meaning, it must be reported as ordinary income on your tax return. This amount is typically included in Box 1 of the W-2 form your employer sends you. 

If you then sell the shares acquired from exercising NSOs, any further gain above the FMV at exercise is typically taxed as a capital gain, either short- or long-term capital gain. 

You must report these stock sales on Form 8949 and Schedule D of your Form 1040 or as applicable. 

Let’s look at four specific tax scenarios. 

Scenario 1: Exercise your option to purchase, but hold onto your shares.

Here, the recipient exercised the option but did not sell the shares. Let’s assume the recipient purchased 100 shares on 7/1/24 for $10, when the market price was $25.

The compensation element is the difference between the market price ($25) and the exercise price ($10), times the number of  purchased shares:

$25 - $10 = $15 x 100 shares = $1,500

The recipient’s employer would include the compensation element amount ($1,500) in Box 1 of the 2024 Form W-2. If, for some reason, it’s not included in Box 1, the recipient should add it to Form 1040, Line 7 when filling out their tax return for the year in which they exercise the option.

Scenario 2: Exercise option to purchase and sell shares the same day.

The recipient has exercised their option and did sell the shares. As before, the compensation element is $1,500, and that amount will be included either on Form 1040 or Form W-2 for the year of purchase. 

The next step is to report the sale and value of the stock on the 2024 Schedule D, Capital Gains and Losses, Part I. This is a short-term sale because the stock was held for less than a year (in this case, less than a day).

Let’s determine whether the recipient had a gain or loss. First, we will calculate the difference between the sales price and cost price. We’re assuming the sales price is $25 (market value) and there was a $5 commission for the broker.

1. Cost Basis is the price paid per share, multiplied by the number of shares, plus the compensation reported on the 2024 Form W-2. 

So: $10 x 100 = $1,000. Adding the $1,500 from Form W-2 means the total cost basis is $2,500.

2. The Sales Price is the market price on the date of sale times the number of shares sold, which is $25 x 100 = $2,500. Then subtract the commission ($2,500 - $5.00), which gives a final sales price of $2,495. The recipient will probably be given a 2024 Form 1099-B from the broker who managed the option purchase and sale, which should reflect $2,495 as the proceeds from the sale.
3. Subtract the sales price ($2,495) from the cost basis ($2,500) to see a loss of $5.00, but the recipient still came out well ahead (even after taxes). Why? Because they sold stock for $2,495 (after paying the commission) that they purchased for only $1,000.

Scenario 3: Exercise your option to purchase and sell within a year or less from the date of purchase.

This example is similar to Scenario 2, because selling the stock within a year means this is still a short-term purchase. This means that the compensation element is $1,500, which will be reported as explained above, and the sale must be reported on the 2024 Schedule D. 

In this case, assume the stock was sold on 12/30/2023 and the market price was $30 with a $10 broker’s commission. 

1. The Cost Basis is $10 x 100 = $1,000, plus the previously calculated compensation element of $1,500 for a total of $2,500. 
2. The Sales Price is ($30 x 100) - $10.00, or $2,990. Form 1099-B from the broker handling the sale should report $2,990 as the proceeds.
3. $2,500 - $2,990 equals a gain of $490, which will be taxed as short-term capital gain at the ordinary income tax rate.

Scenario 4: Exercise the option to purchase, and sell after more than a year. 

Finally, consider a situation in which the option is exercised but the stock is sold after a year. Let’s assume the recipient bought the stock in 2022 with the same compensation element of $1,500 as in the previous examples; this would have appeared in their W-2 for 2022. It no longer needs to be reported on the returns as it’s part of the cost basis purchase price. 

The stock is now being sold in 2024 with the same market price ($30) and broker’s commission ($10) as the previous example. Once again, the stock sale gain is $490, calculated the same way, and will be reported on the 2024 Schedule D, Part II. 

This time, however, the gain is considered long-term, so the recipient will only pay tax at the capital gains rate, which is probably lower than the regular income tax rate.

FAQs about non-qualified stock options

Can you sell non-qualified stock options?

No, NSOs cannot be directly sold. To realize value from them, the recipient must purchase the shares; once owned, the recipient can hold or sell as desired.

Should you accept non-qualified stock options as compensation?

This depends on several factors. NSOs can provide an opportunity for significant gains if the company's stock price appreciates, but there is also risk if the stock underperforms. You should evaluate the company's growth prospects, risk tolerance, and what percentage of your total compensation the NSOs represent. 

Are non-qualified stock options and early exercisable stock options the same thing?

No, NSOs and early exercisable stock options are not the same thing. NSOs are a type of compensatory stock option where you have the choice to purchase shares at a preset price after meeting a vesting schedule. With early exercisable options, on the other hand, you can exercise the options before they vest, though shares remain subject to the vesting schedule. The early exercise feature provides potential tax advantages but requires paying the exercise price upfront before the shares fully vest. 

Conclusion: Rho can help you maximize time for strategy

NSOs are a form of equity compensation that companies grant to employees and non-employees (e.g. contractors and service providers). 

This type of compensation does not receive special tax benefits. There are multiple methods by which to exercise the NSO, including exercise and hold, exercise and sell, and exercise to cover. Each of these methods has its own advantages and disadvantages.  

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Note: This content is for informational purposes only. It doesn't necessarily reflect the views of Rho and should not be construed as legal, tax, benefits, financial, accounting, or other advice. If you need specific advice for your business, please consult with an expert, as rules and regulations change regularly.

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