- Non-qualified stock options: How NSOs work and tax treatment
- What are non-qualified stock options?
- Who can receive non-qualified stock options?
- How non-qualified stock options work
- How are non-qualified stock options taxed?
- Taxes when you exercise
- Taxes when you sell your shares
- The qualified small business stock exclusion
- When can you exercise non-qualified stock options?
- NSOs vs. other equity types
- NSOs vs. ISOs
- NSOs vs. RSUs
- NSOs as equity compensation: pros and cons
- Using NSOs as part of your equity strategy
- Frequently asked questions about non-qualified stock options
What are non-qualified stock options?
Non-qualified stock options (NSOs) are a type of stock option that grants employees, consultants, advisors, board members, and other service providers the right to purchase company stock at a fixed price, known as the strike price or exercise price. Unlike incentive stock options (ISO), NSOs do not qualify for special tax treatment under the Internal Revenue Code (IRC). You owe ordinary income tax on the spread when you exercise, though without the tax advantages ISOs can offer.
NSOs typically follow a vesting schedule, which requires the option holder to remain with the company or meet certain milestones before they can be exercised.
Companies often choose NSOs because they can be granted to employees as well as a broader range of non-employee service providers like consultants and startup advisors. Companies also receive a tax deduction equal to the ordinary income recognized by the option holder at the time of exercise.
NSOs offer real upside when the stock appreciates, but exercise triggers an immediate tax bill and investment risk if the share price falls. Talk to a tax advisor before you exercise.
Who can receive non-qualified stock options?
NSOs are the more flexible option type because a company can grant them to almost anyone who provides services. Common recipients include:
Employees at any level of the company
Contractors and consultants
Advisors who lend expertise or connections
Board members and other outside service providers
ISOs work differently, because a company can grant them only to U.S.-based employees. There is also no annual limit on how many NSOs a company can grant, while ISOs come with a yearly cap known as the ISO $100K limit. When an employee's stock grant goes over that limit, the extra options automatically become NSOs. As a result, many employees hold both types at the same time, often as part of their total compensation.
How non-qualified stock options work
On the grant date, you receive the options, but you do not own any company shares yet and you owe nothing. Your vesting schedule then determines when you can buy the shares. When you exercise, you buy your vested shares at the strike price.
The company sets your strike price at the fair market value (FMV) of its common stock on the grant date. For a private company, an independent 409A valuation determines that FMV. When you later exercise, the difference between the FMV at that moment and your strike price is called the spread, and it determines your tax bill at exercise.
How are non-qualified stock options taxed?
With NSOs, you are generally taxed twice. You pay ordinary income tax when you exercise, and you pay capital gains tax when you later sell the shares. Ordinary income is the same category as your wages, while capital gains apply to profit on an asset you own and then sell.
Unlike ISOs, which in most cases allow option holders to avoid ordinary income tax entirely and pay only capital gains tax, NSOs generate a tax bill the moment you exercise.
→ Learn more about how taxes work for stock options
Taxes when you exercise
When you exercise your stock options, you'll be taxed on the difference between your strike price (fixed purchase price) and the current FMV of those stock options. This difference is called the spread, and it counts as ordinary taxable income and is taxed at the same rates as your salary. Note that withholding is calculated at the federal supplemental rate (22%), which may differ from your effective tax rate, potentially resulting in a balance due or refund at filing.
If you are an employee, your company will usually withhold ordinary income tax (including payroll taxes like Social Security and Medicare taxes) on the spread when you exercise or require you to pay the withholding tax out of pocket. If you are an independent contractor or other non-employee service provider, you will have to pay any applicable taxes directly to the IRS.
After exercising the NSOs, any additional gain realized from selling the shares is subject to capital gains taxes. If the shares are held for more than one year after exercise, they qualify for the lower long-term capital gains tax rate. If they are sold under one year from exercise, they are taxed as short-term capital gains.
For example, if you exercise 100 vested options at a grant price of $1 and the current value is $2, you'll owe ordinary income tax on the $100 gain.
Taxes when you sell your shares
After you exercise, your cost basis equals the FMV at exercise, which is your strike price plus the spread you already paid tax on. Only the additional gain above your cost basis is taxed when you sell. How that gain is taxed depends on how long you hold the shares after exercising.
If you sell right away at the current FMV of the stock, you will not have any capital gain and will only have to pay ordinary income tax on the spread. If you sell within a year of exercising your options, you'll pay short-term capital gains tax on any increase in value since the exercise date. But if you hold onto your stocks for more than a year and then sell, you would pay long-term capital gains tax, which is typically a lower rate than the short-term capital gains tax rate. Holding shares this way is also common for employees whose companies are heading toward an initial public offering (IPO).
The qualified small business stock exclusion
After you exercise NSOs and hold stock, it may be eligible for the qualified small business stock (QSBS) tax benefit. If you qualify, you can exclude up to 100% of federal capital gains from the sale, provided you hold for at least five years through a liquidity event such as a tender offer, secondary transaction, or IPO.
2025 legislation raised the individual exclusion cap from $10 million to $15 million and phased in the exclusion for shares issued after July 4, 2025: 50% at three years, 75% at four years, and 100% at five years. The classic rule still applies to shares issued on or before that date, with up to 100% of gains excluded after a five-year holding period, capped at $10 million.
Action | Tax implication |
You exercise your NSOs into stock | Ordinary income tax on the difference between strike price and current FMV |
You exercise NSOs and sell your stock in one transaction | Ordinary income tax on spread; if sale price higher than FMV, short-term capital gains on the difference |
You sell your stock within a year of exercising your NSOs | Short-term capital gains taxes on profit |
You sell your stock after holding it for over a year after exercising your NSOs | Long-term capital gains taxes on profit |
You sell your stock after holding it for over five years after exercising NSOs | May be eligible for the QSBS exclusion, potentially zero federal capital gains taxes. For shares issued on or before July 4, 2025, up to 100% of gains can be excluded after five years, capped at 10 million dollars. For shares issued after that date, the exclusion phases in (50% at three years, 75% at four years, 100% at five years), with the cap raised to 15 million dollars. |
When can you exercise non-qualified stock options?
You can exercise your options once they vest, and you can keep exercising them any time before their expiration date. NSOs usually expire a set number of years after the grant date. Some companies also allow early exercise, which lets you buy options before they fully vest.
If you choose to exercise, you can either pay the strike price in cash or sell a portion of your shares to cover the cost of exercise through a net exercise. Check to see if your company allows this.
If you leave your company, you'll usually have a limited window, called the post-termination exercise period (PTEP), to exercise your vested NSOs. If you don't exercise your options before that window closes, you'll forfeit them.
To maximize your potential profit after taxes, talk to a tax advisor before exercising and selling your non-qualified stock options. While advisors can't predict your company's future stock performance, they can help you understand your next steps and minimize your tax liability.
NSOs vs. other equity types
Companies offer several types of equity, including incentive stock options, restricted stock awards (RSA), and restricted stock units (RSU). Each is taxed differently.
If you are setting up or reviewing option grants, Carta's free stock option plan templates walk through how ISOs, NSOs, and RSUs are structured.
NSOs vs. ISOs
Incentive stock options (ISOs) and NSOs differ in who can receive them and how they're taxed. Only domestic employees can receive ISOs. NSOs are more flexible: your company can also grant them to contractors, advisors, and board members.
The bigger difference is tax treatment. ISOs may qualify for favorable tax treatment, meaning no ordinary income tax at exercise. But exercising ISOs can trigger the alternative minimum tax (AMT). NSOs pay ordinary income tax on the spread at exercise, but do not trigger AMT.
Here's how the two compare:
Feature | ISOs | NSOs |
Eligibility | Domestic employees only | Employees, contractors, advisors, board members |
Tax at exercise | No ordinary income tax | Ordinary income tax on the spread |
AMT | Can be triggered at exercise | Not triggered |
Holding-period benefit | All gain can be long-term capital gains after a qualifying disposition | Post-exercise gains taxed as long-term capital gains after one year |
Both option types can qualify for long-term capital gains rates if you hold the shares long enough after exercise. The right fit depends on your role and your tax situation, so it helps to talk with a tax advisor before you exercise.
NSOs vs. RSUs
NSOs and restricted stock units (RSU) are both equity, but they work differently. An NSO is the right to buy shares at a set strike price. It only has value if the FMV of the stock rises above your strike price, and you have to pay to exercise.
An RSU is a grant of shares with no purchase price. You don't buy anything. Once your RSUs settle at vesting, the shares are yours and are taxed as ordinary income based on their value at that time.
With NSOs, you decide when to exercise and pay the strike price, which gives you some control over timing but also puts your own money at risk. With RSUs, you receive value as long as the shares are worth anything, though you usually give up the choice of when to trigger a taxable event.
→ Learn more about RSUs vs. stock options
NSOs as equity compensation: pros and cons
NSOs are a common way to reward employees and non-employees alike.
For companies and recipients, the main advantages are:
Broad eligibility: you can grant NSOs to employees, contractors, advisors, and board members.
No AMT exposure: exercising NSOs does not trigger the alternative minimum tax.
Upside potential: recipients benefit if the share price climbs above the strike price.
Employer deduction: the company gets a tax deduction equal to the income the recipient reports at exercise.
The drawbacks are:
Tax at exercise: you owe ordinary income tax on the spread the year you exercise, even if you don't sell.
Out-of-pocket cost: you have to pay the strike price to exercise.
Investment risk: your shares can lose value if the company's stock price falls.
ISOs remain the most common employee grant type. In Carta's analysis of equity at private equity (PE)-backed corporations, more than 50% of initial equity grants are ISOs, compared with over 25% NSOs and 16.5% RSUs. Those numbers reflect PE-backed companies specifically; the mix often looks different at earlier-stage startups.
Using NSOs as part of your equity strategy
For founders building a compensation strategy, NSOs offer a practical advantage: you can grant them to employees, advisors, contractors, and board members through a single equity plan. That flexibility matters early on, when your cap table includes more than just full-time employees.
A few things to get right from the start. Set strike prices at or above fair market value at the time of each grant so your options are defensible and compliant. Establish clear vesting schedules that align with how long you expect contributors to stay involved. And make sure your equity plan documents define post-termination exercise periods, early exercise rights, and any company repurchase rights, so there are no surprises when someone leaves.
Carta's equity management software handles the mechanics of running an NSO program, including issuing grants, tracking vesting, and maintaining a clean, accurate cap table as your company grows. When employees have questions about their options, what they're worth, or how taxes work at exercise, Carta's Equity Advisory connects them with equity experts who can walk through the specifics of their situation.
Get a demo to see how Carta can help you set up and manage your equity program from the first grant through exit.
Frequently asked questions about non-qualified stock options
Can you hold my shares after you exercise your NSOs?
Yes. After you exercise, you own the shares outright. Any later gain is a short-term capital gain if you sell within one year and a long-term capital gain if you hold longer.
How do you report non-qualified stock options on your taxes?
The spread at exercise shows up on your Form W-2, or on a Form 1099 if you are a non-employee. When you sell, you report the sale on the capital gains forms your broker and the IRS provide. If your employer or company doesn't include the spread on your W-2 or issue a Form 1099-NEC, you're still responsible for reporting the gain on Schedule 1, Part I, Line 8 of your tax return.
When should you exercise your non-qualified stock options?
There's no single right answer, and the timing depends on your situation. Many option holders weigh the current spread, their expected tax bill, and their view of the company before exercising. Talk to a financial advisor before you decide.
Do NSOs expire?
Yes. NSOs typically expire ten years from the grant date, though your plan may set a shorter window. If you leave the company before then, the expiration that matters most is your post-termination exercise period (PTEP), which is usually 90 days from your last day. If you don't exercise your vested options before the PTEP ends, you forfeit them regardless of how much time remains on the original expiration date. Check your grant agreement for the exact terms.
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