What Is a Non-Qualified Stock Option and How It’s Taxed?

A non-qualified stock option, or NSO, is a contract that lets you buy a set number of your company’s shares at a fixed price, and it is taxed in two stages: ordinary income tax on the spread when you exercise, then capital gains tax on any further appreciation when you sell. That two-stage structure is what makes NSOs and how they are taxed different from most other forms of pay. Companies can grant NSOs to employees, contractors, consultants, and board members, which is why they show up in so many compensation packages.

What Your Grant Actually Gives You

Every NSO grant fixes three numbers in writing: the grant date, the strike price you will pay per share when you exercise, and the expiration date. Ten years from the grant date is the typical expiration. Miss it and the options are gone.

You cannot exercise on day one. A vesting schedule controls when you earn the right to buy. A common structure is four years with a one-year cliff: nothing vests until your first anniversary, then the rest vests monthly or quarterly over the following three years. Leave before an option vests and you forfeit it.

If the stock trades below your strike price, the option is “underwater.” Exercising would mean paying more than the shares are worth, so you wait. Some companies reprice underwater options or swap them for new grants at the current market price.

Tax at Exercise: The Main Event

The primary tax event happens the moment you exercise, whether or not you sell any shares. The IRS treats the spread — the difference between the stock’s fair market value on the exercise date and your strike price — as ordinary compensation income.¹ Strike price of $10, stock worth $50 on exercise day, spread of $40 per share taxed as income.

If You Are an Employee

The spread lands on your W-2, and your employer withholds like it would on a bonus. Federal withholding on supplemental wages runs at a flat 22 percent, rising to 37 percent on any supplemental wages above $1 million in a calendar year.²³⁴ and state income tax withholding is added at whatever rate your state uses.

Watch the 22 percent number. That withholding rate is often lower than the marginal rate a large exercise pushes you into, which means the taxes withheld may not be enough. The balance is due when you file.

The Additional Medicare Tax

An extra 0.9 percent Medicare surtax applies to Medicare wages above $200,000 for single filers, $250,000 for joint filers, or $125,000 for married filing separately.⁵ A single large NSO exercise easily clears these thresholds, and the surtax catches many option holders who did not plan for it.

If You Are a Contractor or Board Member

Non-employees get a Form 1099-NEC rather than a W-2, and nothing is withheld at the source.⁶ You owe self-employment tax on the spread — both halves of Social Security and Medicare, totaling 15.3 percent (12.4 percent Social Security plus 2.9 percent Medicare).⁷ Ordinary income tax on the spread is on you as well, generally through estimated payments.

Tax When You Sell the Shares

If you keep the shares rather than selling at exercise, a second tax event waits for you at sale. Your cost basis is the fair market value on the exercise date — the price you already paid ordinary income tax on — not the strike price you actually paid. Only the change in value after that point is taxed at sale.

Holding Period Matters

Hold more than one year after exercise and any gain qualifies as long-term capital gain, taxed at 0, 15, or 20 percent for 2026 depending on your taxable income and filing status.⁸ For a single filer in 2026, the 0 percent bracket runs up to $49,450, 15 percent applies through $545,500, and 20 percent applies above that.⁹ Sell inside a year and the gain is short-term, taxed at your ordinary rate.

Net Investment Income Tax

An additional 3.8 percent net investment income tax applies to capital gains once modified adjusted gross income tops $200,000 single, $250,000 joint, or $125,000 married filing separately.¹⁰ Stacked on top of the 20 percent long-term rate, that pushes the federal ceiling on long-term gain to 23.8 percent before state tax.

If the Stock Drops After Exercise

A share price below your cost basis at sale produces a capital loss. Losses offset capital gains on your return, and any excess loss can offset up to $3,000 of ordinary income each year, with the rest carried forward.⁸ The trap here is real: you already paid ordinary income tax on the spread at exercise, and a later price drop does not undo that. You can be out of pocket on tax for gains you never actually kept.

How You Pay the Strike Price

Vested options can be exercised three ways, and the choice affects how much cash the exercise actually costs you:

Cash exercise. You pay the full strike price yourself and receive the shares. Requires liquidity for the purchase and the tax bill.
Cashless exercise. Your broker sells all the shares at exercise, subtracts the strike price and tax withholding, and hands you the net cash. You never hold the stock.
Sell-to-cover. The broker sells just enough shares to pay the strike price and withholding, and you keep the rest.

Cashless and sell-to-cover generally require a public market for the shares, which is why cash exercise is often the only choice at a private company.

Early Exercise and the 83(b) Election

Some companies, especially early-stage startups, allow you to exercise options before they vest. If you do, you can file a Section 83(b) election with the IRS within 30 days of the purchase to be taxed on the spread at exercise rather than as each tranche later vests.¹¹ The planning value is highest when the strike price equals current fair market value: the spread is zero, so the election locks in no ordinary income at all, and future appreciation is taxed as capital gain at sale. Miss the 30-day window and the election is gone.

Deferring Tax at a Private Company: Section 83(i)

Employees of certain private companies can elect under Section 83(i) to defer the ordinary income tax at exercise for up to five years.¹¹ This exists because paying ordinary income tax on a spread you cannot monetize — the shares are not publicly traded — is a genuine cash-flow problem.

Every condition below has to be satisfied:

The company’s stock is not publicly traded, and a written plan grants stock options or RSUs to at least 80 percent of U.S. employees that calendar year.
You are not the CEO, CFO, one of the four highest-paid officers, or a 1 percent owner, and have not been any of those in the preceding 10 years.
You file the election within 30 days after the shares vest or become transferable, whichever is earlier.
The shares are held in escrow until the company recovers the withholding it owes on the deferred amount.

Deferral ends at the earliest of the stock going public, you becoming an excluded employee, you selling or transferring the shares, five years after vesting, or you revoking the election. At that point the original spread is included in income and taxed at ordinary rates.

How NSOs Compare to Incentive Stock Options

If your company grants both, do not treat them as the same instrument. ISOs are limited by federal statute to employees only,¹² while NSOs can go to contractors, board members, and consultants. Federal tax rules classify any option that is not an ISO or granted under an employee stock purchase plan as non-qualified.¹

On tax, an ISO exercise triggers no regular income tax, though the spread counts for alternative minimum tax purposes. An NSO exercise triggers ordinary income tax on the full spread with no AMT quirk. ISOs also require a two-year hold from grant and one year from exercise for favorable capital gains treatment; NSOs use only the standard one-year holding period for long-term capital gains.

Leaving the Company

Unvested options are typically forfeited the day you leave. Vested options have to be exercised within a limited post-termination window, most commonly 90 days, though some plans set 30 days and others as long as 10 years. Death or long-term disability may accelerate vesting and lengthen the window; retirement terms vary by plan.

The tax squeeze at a private company is real. If you have to exercise within 90 days of leaving, you owe ordinary income tax on the spread even though you cannot sell shares on a public market to fund it. Some departing employees let valuable options expire rather than write the check.

Section 409A and the Pricing Risk You Carry

Section 409A of the Internal Revenue Code governs deferred compensation, and NSOs land inside it if the strike price is set below fair market value on the grant date. If a grant fails 409A — usually because the company undervalued its stock at pricing — the consequences fall on you, not the company. All deferred compensation under the plan becomes immediately taxable, plus a 20 percent penalty tax and an interest charge running from the year the options originally vested.¹³

Public companies price to the closing stock price on the grant date. Private companies need an independent valuation, commonly refreshed annually or after a major funding round. Before signing a grant at a private company, confirm a current 409A valuation exists — you are the one who pays if it does not.

Clawback and Forfeiture Language

A vested option is not necessarily a secure option. Forfeiture clauses commonly cancel vested but unexercised options if you are terminated for cause, which plan documents typically define to include dishonesty, criminal convictions, breach of confidentiality, and policy violations. Clawback clauses go further, letting the company recoup gains from options you already exercised and sold — usually tied to financial restatements caused by executive misconduct, and sometimes to breach of a non-compete or non-solicit after you leave. Read the specific language in your grant agreement before assuming any option, vested or exercised, is beyond reach.

1
Internal Revenue Service. Topic No. 427, Stock Options
2
Internal Revenue Service. Publication 15 (2026), Employer’s Tax Guide
3
Internal Revenue Service. Topic No. 751, Social Security and Medicare Withholding Rates
4
Social Security Administration. Contribution and Benefit Base
5
Internal Revenue Service. Topic No. 560, Additional Medicare Tax
6
Internal Revenue Service. About Form 1099-NEC
7
Social Security Administration. FICA and SECA Tax Rates
8
Internal Revenue Service. Topic No. 409, Capital Gains and Losses
9
Tax Foundation. 2026 Tax Brackets and Federal Income Tax Rates
10
Internal Revenue Service. Topic No. 559, Net Investment Income Tax
11
Office of the Law Revision Counsel. 26 USC 83 – Property Transferred in Connection With Performance of Services
12
Office of the Law Revision Counsel. 26 USC 422 – Incentive Stock Options
13
Office of the Law Revision Counsel. 26 USC 409A – Inclusion in Gross Income of Deferred Compensation Under Nonqualified Deferred Compensation Plans