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What Is a Non-Qualified Stock Option (NSO), and How Is It Used?

By

James Chen

Updated December 13, 2023

Reviewed by

Lea D. Uradu

Fact checked by

Vikki Velasquez

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

A non-qualified stock option (NSO) is a type of employee stock option wherein you pay ordinary income tax on the difference between the grant price and the price at which you exercise the option.

NSOs are simpler and more common than incentive stock options (ISOs). They are called non-qualified stock options because they do not meet all of the requirements of the Internal Revenue Code to be qualified as ISOs.

Key Takeaways

Non-qualified stock options require payment of income tax of the grant price minus the price of the exercised option.
NSOs might be provided as an alternative form of compensation, especially in early-stage companies.
NSOs allow employees to assume some of the risks of a new business, but they can also earn higher rewards if the company succeeds.
NSOs allow the holder to buy a company's stock at a preset price at some time in the future. If the holder does not exercise them before the expiration date, they lose the option.

How Non-Qualified Stocks (NSOs) Are Used

Non-qualified stock options give employees the right, within a designated timeframe, to buy a set number of shares of their company’s shares at a preset price. It may be offered as an alternative form of compensation to workers and also as a means to encourage their loyalty with the company.

Important

Non-qualified stock options often reduce the cash compensation employees earn from employment.

The price of these stock options is typically the same as the market value of the shares when the company makes such options available, also known as the grant date. Employees will have a deadline to exercise these options, known as the expiration date. If the date passes without the options being exercised, the employee would lose those options.

There is an expectation that the company’s share price will increase over time. That means employees stand potentially to acquire stock at a discount if the grant price—also known as the exercise price—is lower than later market prices. However, the employee will pay income tax against the difference with a market share price of the stock when the option is exercised. Once the options are exercised, the employee can choose to sell the shares immediately or retain them.

Non-qualified stock options (NSOs) allow employees to buy a company’s shares at a preset price.

As with other types of stock options, non-qualified stock options can be a way to reduce the cash compensation that companies pay directly to their employees while also connecting part of their compensation to the growth of the companies.

The terms of the options may require employees to wait a period of time for the options to vest. Furthermore, the employee could lose the options if they left the company before the stock options are vested. There might also be clawback provisions that allow the company to reclaim NSOs for a variety of reasons. This can include insolvency of the company or a buyout.

For smaller and younger businesses with limited resources, such options that can be offered in lieu of salary increases. They can also be used as a recruiting tool to make up for shortcomings in the salaries offered when hiring talent.

When Should You Exercise Non-Qualified Stock Options?

The best time to exercise a non-qualified stock option is when the share value is higher than the cost of exercising the option, but before the option expires. This should ensure that the stock is more valuable than the cost of buying it.

How Are Non-Qualified Stock Options Taxed?

When you exercise non-qualified stock options, you must pay taxes on the difference between the market price and the exercise price. This is called the compensation element, and it will be reported on your W-2 as income. When you sell the stock, you must also report the capital gain (or loss) between the original market price and the sales price. This will be reported on Schedule D, Capital Gains or Losses. If you sell after less than a year, it is considered a short-term capital gain and taxed at your ordinary income level. If you sell after a year or longer, you will pay a long-term capital gains tax at a lower rate in the year of the actual sale.

Should You Accept Non-Qualified Stock Options As Compensation?

In general, stock options are riskier than salary compensation, but potentially more lucrative if the company has a chance for strong growth. When offered non-qualified stock options, employees should consider their company's risks and the potential value of their shares, both in dollar value and as a percentage of the company's total equity. If they are offered only a tiny percentage of their company or it has a low chance of growth, employees may be better off negotiating for a higher salary instead.

The Bottom Line

Non-qualified stock options are an alternative form of compensation that allows employees to gain equity in the employer's company. They allow the employee to buy shares in the company at a discounted price, with the expectation that these shares will appreciate if the company succeeds. As with any stock, this comes with an element of risk, and employees should consider the potential future of the company when they consider these options.

Article Sources

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