NSO stock options: How non-qualified stock options work
Understanding NSO stock options
Getting employee stock options can be both exhilarating and confusing. On one hand, stock options can sometimes hold significant upside. On the other hand, employees often don't fully understand what they've been granted or what the value of their stock options might be, let alone how to incorporate them into their financial plan.
Here, we'll examine one of the more common types of stock options: Non-qualified stock options (NSOs), also known as nonstatutory stock options.
What are NSO stock options?
NSOs are a type of stock option often used at private companies. Like other stock options, NSOs give employees the right, but not the obligation, to purchase company shares at a predetermined price.
The names nonstatutory or non-qualified stock options might sound negative, but the "non" essentially just refers to not meeting IRS criteria for being a statutory stock option. As such, NSOs generally don't receive quite as friendly tax treatments as statutory stock options such as incentive stock options (ISOs), but they have benefits like being technically transferable (if your company allows it), and non-employees can receive them.1
Some of the notable differences between NSOs and other types of equity-related compensation are outlined in further detail below.
How do NSO stock options work?
If you own NSOs, you have the right to buy an equivalent number of shares of company stock at a given price, known as the strike price or exercise price. This amount is generally set at or above the fair market value of the company at the time of the NSO grant.
If your company goes through several funding rounds and eventually has an IPO, for example, the price per share might increase above your strike price. By exercising those options and then selling your shares, you could profit based on the gap between the current stock price and your strike price.
Stock options, including NSOs, also generally have a vesting period. Until the options vest, you don't fully own them. For example, a private startup might have a four-year vesting period with a one-year cliff. That could mean 25% of your NSOs vest after the first year, but if you leave the company before then, you might not be able to exercise any of your options.
After that first year, you might vest 2.08% monthly, until reaching 100% vested status after the fourth year. At that point, you could exercise all remaining unexercised options, even if you leave the company — though leaving often triggers a 30-90 day exercise window, depending on the company and your role. That said, NSOs generally have more post-termination flexibility than ISOs. Still, NSOs, like ISOs, usually have to be exercised at a maximum of within 10 years from the initial grant date, even if you remain with the company.2
If you're not sure what type of stock options you have or how they apply to your situation, consult your employer or a trusted professional like a financial advisor. Some of the differences can be subtle, but you'll want to know what type you have to make the best tax and overall financial decisions.
How are NSO stock options taxed?
Understanding the tax treatment of NSOs at each stage of the option lifecycle can help you plan ahead and avoid surprises.
At grant. Usually, NSOs don't have a readily determinable fair market value (FMV), so you likely wouldn't be taxed at grant.3 If the FMV is readily determinable, though, it's taxed as property, which may mean you owe income taxes at grant, depending on some nuances around the specific options.4
At vest. NSOs without a readily determinable FMV are also not taxed when they vest. Vesting simply means you've earned the right to exercise; no taxable event typically occurs until you actually do so.
At exercise. For NSOs without a readily determinable FMV, the first taxable event typically occurs when you exercise the options. Generally, the spread between your strike price and the fair market value on the exercise date is taxed as ordinary income.5 Your employer will typically withhold taxes on this amount, and it will appear on your W-2.
At sale. Once you hold the actual shares, any subsequent gain or loss upon sale is generally subject to capital gains tax. Whether the rate is long-term or short-term depends on how long you hold the shares after exercise. Consulting with a tax professional or financial advisor is recommended, given the complexity and financial considerations of stock option and capital gain taxation.
NSOs vs. ISOs
On the surface, NSOs and ISOs might seem interchangeable, as they both can give you the option to buy company stock, but they differ in a few main areas. For one, ISOs are only for employees, whereas NSOs can be for employees along with others that companies might want to grant stock options to, like advisors and board members. ISOs also generally cannot be transferred and are subject to a $100,000 annual limit based on the aggregate FMV of shares that first become exercisable in a given calendar year, measured at the time of grant. (any portion over this amount or that doesn't meet other ISO requirements is then considered an NSO).6 Another key difference is that ISOs typically have to be exercised within 90 days of leaving a company,7 whereas NSOs have more flexibility in these areas.
Perhaps the biggest difference comes down to taxes.
As noted above, NSOs can incur income tax when granted if you can readily determine the FMV. If not, they can count toward income when exercised, based on the difference between the value at the time of exercise and what you paid for them. Then, once you own the actual stock shares, you could be responsible for capital gains tax if you eventually sell for a profit.8
ISOs, however, do not necessarily incur income taxes when granted or exercised, although exercising ISOs could trigger the alternative minimum tax (AMT). Instead, ISOs can potentially delay taxation until you eventually sell exercised shares, which could be taxed at a lower capital gains rate if you meet holding period requirements.4
Overall, ISOs are generally considered to be more tax-friendly, while NSOs are more flexible. The rules and financial implications around stock options can be complex, so you should consult with a tax professional or financial advisor to make sure you handle everything correctly.
NSOs vs. RSUs
NSOs give you the option to buy stock, but you might decide to never exercise them if the company's valuation falls below your strike price. In comparison, restricted stock units (RSUs) are actual shares that you acquire as they vest. You don't have to pay to exercise RSUs; you simply receive the shares. So, unless a company goes to $0, RSUs always retain some value, whereas stock options like NSOs can be more speculative in terms of whether they'll hold future value.
RSUs are taxed when you receive the actual shares, with the value counting as ordinary income. Then, when you sell the shares, you could pay capital gains taxes on additional profits.9 So, while NSOs might not be as guaranteed as RSUs, the initial tax bill might be smaller when comparing equal amounts of NSOs to RSUs.
It's also more common for RSUs to be used by public companies (and occasionally late-stage private companies), as opposed to early-stage startups, which often prefer to use stock options to compensate early-stage employees.
How to value NSOs
In some cases, a private startup's stock might trade on a secondary marketplace like Forge, which could help you assess the current value of your NSOs. To speculate what they might be worth in the future, you could analyze trading activity for similar types of companies.
You can also look at funding round valuations for your current company as well as similar ones to get a better sense of the stock's potential trajectory. That said, valuing stock options can still be tricky and subjective, so you might want to consult with a financial advisor to better understand what yours could be worth.
Exploring liquidity for your NSO shares
For NSO holders at private companies, understanding your options goes beyond tax planning. Whether you're approaching a potential IPO or exploring a sale before one, Forge's marketplace may connect eligible shareholders with potential buyers and provides pricing data for private company shares, subject to share availability, buyer demand/eligibility and transfer restrictions.
That means once you are able to exercise your NSOs, you may then be able to sell shares through a private marketplace such as Forge, rather than waiting for a liquidity event like an IPO.
To start exploring what may be possible for your situation, create a free account.
Frequently asked questions about NSOs
Are NSOs taxed twice?
NSOs are not technically taxed twice on the same income. The spread at exercise is typically taxed as ordinary income, and any additional gain (or loss) when you eventually sell the shares is taxed as a capital gain (or recognized as a capital loss). These are two separate taxable events on two different portions of the total return, not a double tax on the same amount.
What is the $100,000 rule for stock options?
The $100,000 rule applies to ISOs, not NSOs. Under IRS guidelines, no more than $100,000 worth of ISOs (based on fair market value at grant) can become exercisable for the first time in any calendar year. Any portion exceeding that threshold is treated as a non-qualified stock option for tax purposes.6 Because NSOs are not subject to this limit, the rule primarily affects employees who hold large ISO grants.
When should you exercise NSO stock options?
Exercising NSOs depends on several factors, such as whether the company's valuation is above your strike price and your potential tax consequences at the time of exercising. You'll also generally want to be confident that you can then sell exercised shares at some point for a profit, whether that's through a private marketplace like Forge or via public markets after an IPO. Speaking with a tax or financial advisor can help you better determine if and when to exercise.
How do you report non-qualified stock options on a tax return?
When you exercise NSOs, the ordinary income from the spread is typically reported on your W-2 by your employer. Generally, you then report this income on your federal tax return as wages. If you later sell the shares, you report the capital gain or loss on Schedule D and Form 8949.10 A tax professional can help ensure accurate reporting.
