What are Non-Qualified Stock Options (NSOs)?
NSOs are stock options that work exactly like ISOs logistically for employees, but they’re taxed differently. Both give you the right to buy company stock at a set price (the strike price), and both create a benefit for you if the stock rises above that price.
ISOs are a narrower, “qualified” category of stock options with strict rules. They can only be granted to employees, and only $100,000 worth (based on the stock’s value on the grant date) can first become exercisable in any calendar year. Any option that doesn’t meet the ISO rules is an NSO, and companies can choose to grant only NSOs and skip ISOs altogether. NSOs can also be granted to people who aren’t employees, like contractors, advisors and board members, which ISOs can’t.
So at its core, an NSO is the right to buy stock at a specified price, which creates a benefit for you if the stock appreciates. The key difference is that NSOs make that benefit taxable when you exercise, every time, which isn’t the case for ISOs. That makes things simpler: you know you’ll pay ordinary income tax on the benefit when you exercise, and there’s no AMT risk.
How are NSOs taxed?
When you exercise, the difference between the stock’s value and your strike price is taxed as ordinary income. For employees, it’s included on your W-2 and is subject to income tax, Social Security and Medicare. For non-employees, it’s reported on a 1099-NEC and subject to self-employment tax.
Your cost basis in the shares becomes what you paid plus the amount you were taxed on. From there it’s normal capital gains treatment. If you hold the shares for more than one year after exercise, the gain is long-term. Otherwise it’s short-term and taxed at ordinary rates. There’s no special holding period like there is with ISOs.
Example: You have 1,000 NSOs with a $10 strike price, and the stock is now worth $50. You exercise, paying $10,000 for shares worth $50,000. You now have $40,000 of ordinary income on your W-2, and your employer withholds federal income tax at the flat 22% supplemental wage rate, which is $8,800, plus Social Security and Medicare.
What are common tax issues with NSOs?
Not enough tax withheld
This is the same issue as with RSUs. The default 22% withholding often isn’t enough. If you’re in the 35% bracket, you owe $14,000 on that $40,000, so you’re $5,200 short on this one exercise. If you don’t cover that gap with estimated payments or extra withholding, you can end up with a surprise bill and an underpayment penalty on top of it.
The cash it takes to exercise
The more practical issue is cash. You need money to pay the strike price, and the withholding has to be paid at exercise too. Unlike RSUs, there isn’t always an automatic sell-to-cover. You either pay it in cash, or you choose a sell-to-cover or cashless exercise if your plan offers one. In our example, that’s $18,800 out of pocket ($10,000 for the shares and $8,800 of withholding) before even counting the shortfall. At a private company, where you may not be able to sell any shares, that can be a real barrier.
Paying tax twice on the same income
You might expect double taxation to be less of a risk with NSOs since you actually paid for the shares, but it’s one of the most common places it happens. Since 2014, brokers have been required to report only what you actually paid, your strike price, as the cost basis on Form 1099-B. The $40,000 you were already taxed on through your W-2 isn’t included.
Say you hold the shares from our example for more than a year and sell them at $60, for $60,000:
- Basis as reported on the 1099-B ($10,000): a $50,000 gain, or $10,000 of tax at a 20% long-term rate.
- Correct basis ($50,000): a $10,000 gain, or $2,000 of tax.
If you don’t adjust the basis on Form 8949, you pay $8,000 more in tax than you owe. Your broker’s supplemental statement usually shows the adjusted basis, but it’s up to you (or your tax preparer) to use it.
NSOs are the simpler option from a tax-planning standpoint, with no AMT and no special holding period. But between the cash requirements and the reporting traps, the timing of your exercise still deserves a plan.
This article is for general educational purposes and is not tax advice for your specific situation. Figures reflect 2026 federal tax rules.