A non-qualified stock option (NSO, also called an NQSO) is a type of employee stock option that gives you the right to purchase company stock at a fixed strike price. NSOs do not require employment and their expiration can be extended well beyond 90 days, although they do not come with the same favorable tax benefits as ISOs. This means they can be granted to contractors, advisors, and other non-W2 recipients.

What Does NSO Stand For?

NSO stands for non-qualified stock option, sometimes written as NQSO. "Non-qualified" means the option does not qualify for the preferential tax treatment the IRS gives to incentive stock options (ISOs). In exchange, NSOs are far more flexible and can be granted to employees and non-employees alike.

How Are NSOs Taxed? NSO Tax Treatment

NSOs are subject to ordinary income taxes based on the spread between the current FMV and the strike price of the option. As opposed to ISOs, NSO holders will pay taxes which are withheld when exercised. NSOs do have the possibility of an IRS Section 83(i) election where you can defer taxes for 5 years.

The minimum NSO exercise withholding requirement is only 22% for up to $1 million in spread value (37% if over $1 million). Many companies try to estimate the right amount but it isn't very easy. Companies are required to withhold NSO taxes only for employees. Contractors can be given a 1099 instead, meaning they handle their own payments via quarterly estimated taxes. Regardless of whether the company withholds taxes or you make estimated payments, you will true it up to the required amount when you actually file taxes. That could result in a refund or additional taxes, similar to how lottery winners are often surprised that they owe more despite mandatory withholding at the beginning. If you sell NSO shares you are also responsible for paying quarterly estimated taxes which you calculate yourself. If you don't pay enough, there are interest penalties when you file next April. Additionally, Medicare, Social Security taxes, and Federal Unemployment Tax are charged on NSO exercises.

If NSOs are sold within a year of exercising after ordinary income tax was paid on the original exercise, short term capital gains are paid on the spread between the final sale price and the FMV at the time of exercise. The short term capital gains on the portion of the income above the FMV from the sale of NSOs can be offset by other capital losses you may have that tax year.

How Long Do NSOs Last? (Expiration)

Unlike ISOs, which typically expire 90 days after you leave a company, NSOs can be granted with expiration windows extending up to 10 years from the grant date. This makes NSOs more forgiving if you leave your employer, although the exact terms depend on your grant agreement.

NSO vs ISO

The key difference is tax treatment: ISOs can qualify for preferential capital gains treatment (and are taxed via AMT at exercise) but only for employees, while NSOs are taxed as ordinary income at exercise and can be granted to anyone. For a full side by side, see our guide on the difference between ISOs and NSOs.

Exercising NSOs and Covering the Tax

Because NSOs trigger ordinary income tax at exercise, the combined cost of the strike price plus tax withholding can be substantial, often far more than employees expect. ESO Fund can provide non-recourse funding to cover both the exercise cost and the taxes, so you can exercise without spending your own cash. If the company never reaches a liquidity event, you owe nothing. Learn more about funding your option exercise.

Written by Jordan Long, Marketing Lead at ESO Fund