What Is a Non-Qualified Stock Option (NSO)?

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DEFINITION
A non-qualified stock option (NSO) is a form of equity compensation that can be provided to employees and other stakeholders.

A non-qualified stock option (NSO) is a form of equity compensation that can be provided to employees and other stakeholders. An NSO gives recipients the choice to purchase a company’s stock at a predetermined price, which can be profitable if the stock price rises above that level.

Learn how these types of options can benefit employees as well as how their tax advantages compare to other options.

Definition and Examples of Non-Qualified Stock Options

An NSO gives option holders such as employees or independent advisors the opportunity to purchase a company’s stock at a given price, known as the exercise price or strike price.

Ideally, the market will rise above the exercise price by the time the employee or other stakeholder exercises the options (purchases the shares). That way, the option holder can sell the stock for more than they purchased the options for and earn a profit.

For example, an employee might receive stock options that have an exercise price of $10 per share. If the employee had the option to purchase 100 shares, they could pay $1,000 to exercise those options at $10 per share.

If the stock price rose to $20 per share, the employee could exercise the options for $1,000, then sell the 100 shares for $20 per share, or $2,000. So they’d make $1,000 in profit. Or the employee could hold the shares and hope that the stock price rises even more, which would make the stock options more profitable.

Tax Considerations

NSOs do have some unique tax characteristics. Generally, you have to pay ordinary income taxes on the difference between the cost to exercise the options and the value of the options at the time you exercise them, even if you don’t sell the shares right away. So, as in the example above, it would be as if you earned an extra $1,000 in income and have to pay income taxes on that.

Then, you would pay capital gains taxes if you held onto the shares after exercising and ended up selling for additional gain. For example, after exercising at $20 per share, suppose the stock rose to $30 per share. If you sold your 100 shares at that price, you would pay capital gains taxes on the additional $1,000 in earnings.

Capital gains taxes are dependent on how long you held the shares.

If you held the stock after exercising for more than one year, you would generally be eligible for long-term capital gains tax rates, which are often 15% to 20%. In comparison, holding stock for a year means gains would be short-term capital gains and would be taxed at ordinary income tax rates, which tend to be much higher.

How Do Non-Qualified Stock Options Work?

NSOs work by a company giving employees or other stakeholders options to buy company shares as part of a compensation package. The shares have a specific exercise price.

Companies then typically have a vesting period, where NSO recipients earn the right to exercise a higher percentage of their NSOs the longer they’re with the company. For example, after two years, an employee might vest 50% of their NSOs, meaning they can only cash in on half of their options, unless they stay longer.

After vesting, NSO recipients can decide when to exercise, based on whether the company’s stock price rises above the exercise price. From there, the options become regular shares, which shareholders can do with as they please.

Employees need to keep in mind any expiration date set by the company, because the options would become worthless if not cashed in before the expiration date.

These types of stock options are fairly common, as they have fewer restrictions than another type of stock option known as an incentive stock option (ISO).

NSOs vs. ISOs

NSOs are generally easier for employers to provide, because they have fewer restrictions than ISOs, such as who can receive them and the value that can be exercised.

However, ISOs can be more tax-friendly, as all earnings could potentially count as long-term capital gains (depending on holding periods). In contrast, with NSOs, the difference between the exercise price and fair market value at the time of exercising can be taxed as ordinary income.

NSOs ISOs
Less restrictive (e.g., non-employees can receive these options) More restrictive (e.g., only employees can receive these options)
Does not receive special tax treatment Qualifies for special tax treatment, but shareholder must hold shares for one year from date of exercise and two years from date of grant
Taxed at the time they are exercised Taxed at the time they are sold
Could be taxed more, as gains at the time of exercising, taxed at ordinary income tax rates Could be taxed less, as all gains could be assessed at long-term capital gains rates, depending on holding period

Key Takeaways

  • Non-Qualified Stock Option (NSOs) provide employees and other stakeholders with the right (but not the obligation) to purchase company stock at a predetermined price.
  • NSOs can be profitable if a company’s stock price rises more than the exercise price.
  • NSOs may not be as tax-friendly as other types of stock options, such as incentive stock options (ISOs).

Article Sources

  1. Schwab. “Stock Options.” Accessed Dec. 20, 2021.

  2. Turbotax. “Non-Qualified Stock Options.” Accessed Dec. 20, 2021.

  3. Morgan Stanley. “Non-Qualified Stock Option Basics.” Accessed Dec. 20, 2021.

  4. IRS. “Capital Gains and Losses.” Accessed Dec. 20. 2021.

  5. Fidelity. “Stock Options.” Accessed Dec. 20, 2021.

  6. Fidelity. “Fidelity Investments.” Accessed Dec. 20, 2021.

  7. Fidelity. “About Stock Options.” Accessed Dec. 20, 2021.