How non-qualified stock options are taxed in the US

Non-qualified stock options (NSOs) are one of the most common forms of equity compensation in the United States—but they’re also among the most misunderstood. While startups and growth-stage companies often include NSOs in compensation packages to attract and retain talent, many recipients underestimate the tax complexity involved. Unlike incentive stock options (ISOs), NSOs don’t qualify for favorable tax treatment under the Internal Revenue Code, meaning recipients may face tax liability at multiple stages: when they exercise their options and again when they sell the stock.

This article unpacks how NSOs work, how they’re taxed, and what individuals can do to make informed decisions when equity meets the IRS. Whether you're a tech employee with unvested shares or a consultant negotiating for equity instead of cash, understanding the mechanics and tax exposure of NSOs is critical.

Non-qualified stock options (NSOs) grant the right to purchase company stock at a predetermined price, known as the strike price. They are typically offered as part of an employee’s or contractor’s compensation package and are structured to reward long-term company growth.

The key distinction between NSOs and ISOs lies in tax treatment and eligibility. While ISOs are limited to employees and offer potential tax deferral benefits, NSOs can be issued to anyone providing services to the company—including consultants, board members, and advisors. This makes them especially popular with startups that rely on flexible or contract-based talent.

Most NSOs follow a vesting schedule, such as a four-year vest with a one-year cliff. This means recipients must remain affiliated with the company for a period of time before they can exercise their right to purchase shares. Once vested, the holder can choose whether and when to exercise the options.

NSOs create a taxable event at the point of exercise. When an option is exercised, the IRS considers the “spread” between the strike price and the current fair market value (FMV) of the stock to be compensation. That spread is taxed as ordinary income, not capital gains.

Here’s a breakdown:

• Strike Price: The fixed price at which the stock can be purchased
• Fair Market Value (FMV): The current value of the stock at the time of exercise
• Spread: The FMV minus the strike price—this is the taxable income

For example, suppose your startup granted you 1,000 NSOs at a strike price of $1. Two years later, the FMV of the company’s shares is $3. If you exercise all 1,000 options, you generate a spread of $2,000. That amount is treated as ordinary income for tax purposes, and you must report it accordingly.

If you are an employee, your employer will likely withhold payroll taxes, including Social Security and Medicare, on the income. If you are a contractor or advisor, the IRS expects you to report and pay the tax independently—usually through estimated tax payments. This is a critical point: You may owe taxes even if you don’t sell the shares and haven’t received any cash. In this way, NSOs introduce a liquidity risk.

After you exercise NSOs and hold onto the shares, the next tax event occurs when you sell. How much tax you pay depends on the holding period after exercise.

• Held < 1 year: Gains from the sale are taxed as short-term capital gains (at your ordinary income tax rate).
• Held > 1 year: Gains qualify for long-term capital gains tax, typically lower than the ordinary rate.

Let’s say you exercised your 1,000 shares at $1 each when the FMV was $3, paying $3,000. A year later, you sell the shares at $10 per share. Here’s how the taxes would break down:

• $2,000 (the spread) was already taxed as ordinary income at exercise
• $7,000 ($10 - $3) x 1,000 shares is taxed as long-term capital gains if held more than a year

This two-step tax treatment makes NSOs significantly different from ISOs, which generally allow holders to defer all taxes until the shares are sold—and may avoid ordinary income tax altogether if certain holding requirements are met.

Some NSO holders choose to exercise and sell immediately—known as a “same-day sale” or “cashless exercise.” In this case, the gain between the strike price and sale price is taxed entirely as ordinary income, and there is no additional capital gains tax because there is no holding period.

This option simplifies the tax situation and avoids the liquidity trap of exercising without selling. However, you lose the chance to benefit from long-term capital gains rates if the stock appreciates substantially in the future. This trade-off—between tax simplicity and future upside—should be carefully considered with a tax advisor or financial planner.

A lesser-known benefit that may apply to NSO recipients is the Qualified Small Business Stock (QSBS) exclusion under Section 1202 of the tax code. If the company qualifies as a “qualified small business” and the shares are held for more than five years after exercise, the taxpayer may exclude up to 100% of federal capital gains tax on up to $10 million of gain.

To qualify:

• The company must have less than $50 million in gross assets at the time of stock issuance
• The business must be engaged in a qualified trade or business (some service-based industries are excluded)
• The shares must be held directly by the taxpayer for more than five years
• The shares must have been acquired upon original issuance—typically at the time of NSO exercise

QSBS status must be verified by the company, and the five-year holding requirement is strict. If you sell even a day before the five-year mark, you lose the tax exclusion. This benefit can be significant, especially for early-stage startup employees or advisors with substantial equity.

If you leave a company, you usually have a post-termination exercise period (PTEP)—often 90 days—to exercise your vested NSOs. If you fail to do so, you forfeit the right to buy those shares, regardless of their value. Some companies may offer extended PTEPs (up to 10 years in rare cases), but many adhere to the 90-day standard. This short window often puts former employees in a difficult position: exercise and incur a potentially large tax bill—or walk away from potentially valuable equity.

Planning ahead is essential. If your company doesn’t offer a cashless exercise option, you may need to prepare liquidity in advance or explore secondary market sales if permitted.

Not all companies require you to front the cash to exercise your NSOs. There are two common alternatives:

1. Cashless Exercise: You sell enough shares at the time of exercise to cover the strike price and any taxes owed. The remaining shares are yours to hold or sell.
2. Net Exercise: Your employer withholds enough shares to cover the cost of exercise and taxes, delivering only the remainder to you. You don’t pay out of pocket, but you end up with fewer shares.

Both methods help mitigate liquidity challenges but may reduce your potential future upside. Always review your company's equity policy and model the tax implications with a professional.

NSO taxation is not just about paying the IRS. It’s about aligning your equity decisions with your broader financial goals and cash flow situation. Here are a few guiding principles:

• Monitor FMV regularly: A significant increase in FMV can inflate the tax bill at exercise. If you're planning to exercise, time it when valuations are low (e.g., before a new funding round).
• Use early exercise if available: Exercising early, when the spread is minimal, can reduce tax liability—but you must also assume the risk of stock devaluation.
• Prepare for taxes: Many recipients forget that exercising creates income. Plan for cash or liquidity to cover it. If you can’t afford the tax, consider deferring.
• Factor in AMT risk for ISOs: While not applicable to NSOs, if you also have ISOs, the alternative minimum tax (AMT) may impact your total tax picture.
• Don’t over-allocate your wealth to employer stock: Concentration risk can hurt if the company underperforms.

Even experienced professionals can miscalculate their exposure, especially if their company undergoes a liquidity event or valuation spike. That’s why financial planning is essential—not just for taxes, but for timing, diversification, and long-term stability.

To put NSOs into context, it helps to understand how they differ from other equity instruments:

• Incentive Stock Options (ISOs): No income tax at exercise (unless AMT applies), but stricter eligibility and holding rules. Reserved for employees only.
• Restricted Stock Units (RSUs): Taxed as income when vested. No exercise required.
• Restricted Stock Awards (RSAs): Taxed when granted (unless Section 83(b) election is made). More common for founders or very early hires.

NSOs are often used for flexibility—they can be granted to anyone performing services. But that flexibility comes at a cost: higher upfront taxation and less favorable holding treatment.

Equity compensation can change your net worth—but only if managed well. NSOs are not “free money,” and they are not guaranteed windfalls. They are opportunities wrapped in regulatory complexity and market uncertainty.

Understanding how NSOs are taxed gives you a head start—but that’s only one part of the picture. The bigger question is: how do these options fit into your financial life? What trade-offs are you willing to make between taxes today and potential upside tomorrow?

If you’re sitting on vested options, don’t wait until your company IPOs or until you leave your role to make a decision. Use the tools available: equity plan documents, FMV reports, 409A valuations, and—most importantly—qualified tax advice. Because in the world of equity, it’s not just about how much your shares are worth. It’s about when, how, and at what cost you turn them into cash.