Non-Qualified Stock Options (NSOs): Taxation Explained

Non-Qualified Stock Options (NSOs), also known as Nonstatutory Stock Options, are a common form of equity compensation offered by companies to employees, consultants, and board members. Unlike Incentive Stock Options (ISOs), NSOs do not qualify for special tax treatment under the Internal Revenue Code. While they can be a valuable benefit, they also come with straightforward—but important—tax consequences.

This article breaks down how NSOs are taxed and how you can plan around them effectively.

What Are NSOs?

NSOs give you the right to purchase company stock at a fixed price (the exercise price) after certain conditions are met—usually after a vesting period. If the stock price rises above your exercise price, you can buy shares at a discount and potentially realize a profit when you sell them.

The key difference between NSOs and ISOs is how they are taxed, both at the time of exercise and at sale.

When Are NSOs Taxed?

NSOs are taxed twice:

  1. When you exercise the option

  2. When you sell the shares

Let’s break it down.

1. Tax at Exercise

When you exercise NSOs, the bargain element—the difference between the fair market value (FMV) of the stock on the exercise date and the exercise price—is considered ordinary income. This income is subject to:

  • Federal and state income tax

  • Social Security and Medicare (FICA) taxes

  • Reported on your W-2 (for employees) or Form 1099-NEC (for contractors)

Example

  • Exercise price: $10

  • FMV on exercise date: $30

  • Bargain element = $20

  • If you exercise 1,000 options: $20 × 1,000 = $20,000 of ordinary income

2. Tax at Sale

After exercising, if you hold the shares and later sell them, you may also owe capital gains tax on the difference between:

  • Sale price and

  • FMV on the exercise date (which becomes your cost basis)

  • If you sell within one year of exercise: short-term capital gains

  • If you sell after one year: long-term capital gains

Continuing the Example

  • FMV at exercise: $30

  • Sale price: $50

  • Capital gain = $50 – $30 = $20 per share

  • If held >1 year: taxed as long-term capital gains

Early Exercise & 83(b) Elections

In some private companies, you may have the opportunity to exercise options early, before they vest. If you do, you can file an 83(b) election with the IRS within 30 days of exercise. This lets you recognize the bargain element as income at the time of exercise, when the FMV may be close to the exercise price—potentially minimizing ordinary income.

However, 83(b) elections come with risk. If the shares decrease in value or never vest, you’ve already paid tax on income you never truly received.

NSOs for Contractors and Advisors

One advantage of NSOs is that they can be granted to non-employees, such as contractors, board members, or advisors. For these recipients:

  • The income at exercise is self-employment income, not wages

  • Taxes are reported on Form 1099-NEC

  • No tax withholding is done by the company—you must handle it yourself

Withholding and Reporting

  • For employees, companies usually withhold taxes at exercise and report the income on Form W-2.

  • For non-employees, the income is reported to you (and the IRS) on Form 1099-NEC, and you are responsible for calculating and paying estimated taxes.

International Considerations

If you’ve worked or lived in multiple countries between the grant, vesting, exercise, or sale of NSOs, income may be taxed in more than one country. Different jurisdictions source income from NSOs in different ways—based on grant-to-vest, vest-to-exercise, or other formulas. Cross-border NSO taxation can be complex and typically requires professional advice.

For more information on the sourcing rules for NSOs, visit the Sourcing page of this website.

Planning Tips for NSOs

  1. Understand your timeline: Know when your options vest, when they expire, and your holding period goals.

  2. Plan for the tax hit at exercise: You’ll owe tax even if you don’t sell the shares.

  3. Be strategic about when you sell: Consider capital gains holding periods.

  4. Watch out for concentration risk: Don’t overexpose your portfolio to your employer’s stock.

  5. Get professional advice—especially if you’re managing large grants, crossing borders

Key Takeaways

  • NSOs are taxed as ordinary income at exercise and capital gain at sale.

  • The bargain element is always taxable at exercise, even if you don’t sell.

  • Holding shares longer than one year after exercise can reduce tax via long-term capital gains.

  • No AMT applies, unlike ISOs.

  • Planning is essential, especially when options are valuable or involve international complexities.

At Zeisei Group, we help clients navigate the full lifecycle of equity compensation—including NSOs, ISOs, RSUs, ESPPs, and international tax implications. If you're exercising options or preparing for a liquidity event, reach out to us for smart, personalized advice.