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Nonqualified Stock Options (NSOs):

Nonqualified Stock Options (NSOs) are often described as “simpler” than ISOs — and structurally, they are. But that simplicity comes with a trade-off: taxes are more immediate, more predictable, and harder to avoid.

With NSOs, the most common mistake isn’t misunderstanding what they are.  It’s misunderstanding when income is recognized and taxes are actually owed, not just when shares are sold.

How NSOs are taxed: start with the timeline

The easiest way to understand NSOs is to separate ownership events from tax events.:

Grant -> Vest -> Exercise -> Sale

At a high level:

  • Grant: You receive the right to buy shares later (not ownership yet)

  • Vesting: You earn the right to exercise (usually not a tax event by itself)

  • Exercise: You buy shares (this is usually the main tax trigger)

  • Sale: You sell shares you already own (capital gains or losses apply)

For the full, cross-option view, see Option Tax Triggers.

What makes an option an NSO:

NSOs are generally the default option type. If an option does not meet the IRS requirements for Incentive Stock Option (ISO) treatment, it is treated as a nonqualified option.

The key distinction:

  • NSOs do not receive special ISO tax treatment.

  • Exercise is typically taxed as compensation under the regular tax system.

There is no AMT layer, but there is also no deferral of income recognition.

Ordinary income at exercise:

When you exercise an NSO, the IRS generally treats the spread as compensation income:

 

  • Fair market value at exercise − strike price = taxable income

This is true even if you do not sell the shares.
 

Why this matters:

  • You can create taxable income without receiving cash

  • The tax result is largely locked in at exercise

  • Waiting does not “improve” the tax character of the spread

This is the single most important NSO rule — and the one most commonly misunderstood.

Withholding and payroll taxes:

Because NSO exercise income is treated like compensation:

  • Withholding may apply at exercise (mechanics vary by plan and company)

  • Payroll taxes (Social Security, Medicare) may also apply

  • Withholding is often insufficient compared to your actual marginal tax rate

This leads to a common outcome:

 

  • “Taxes were withheld — but I still owed much more at filing.”

NSOs often feel simple at exercise and painful at tax time.

Capital gains after exercise:

Once you’ve exercised and own shares, the tax treatment changes.

From that point forward:

  • Any additional change in value is treated as capital gain or loss

  • The holding period for capital gains starts at exercise, not grant

Conceptually:

  • Exercise = compensation income

  • Sale = capital gains or losses on what changed after you became a shareholder

Private-Company NSOs: The Liquidity Trap:

In private companies, NSOs can create a particularly dangerous mismatch:

  • Taxable income at exercise

  • No public market to sell shares

  • Cash required for strike price and taxes

This can result in:

  • Taxes due without liquidity

  • Capital tied up in employer stock

  • Increased concentration risk

The tax rules are the same — but the experience is very different.
(See Private vs Public Company Equity Compensation for context.)

Early Exercise and 83(b) Elections:

Some private-company plans allow early exercise, meaning you exercise options before they are fully vested and receive shares subject to vesting or repurchase.

Where 83(b) comes in:

In these limited situations, an 83(b) election may be available to accelerate taxation when the spread is minimal.

Important boundaries:

  • This applies only in early-exercise scenarios

  • It does not apply to typical NSO exercise or sale timing

  • It introduces real risk if employment ends early

(See 83(b) Explained for details.)

Common NSO Mistakes We See:

  • Assuming taxes only matter when shares are sold

  • Exercising NSOs without modeling total tax liability

  • Relying on withholding as if it were a final tax bill

  • Exercising private-company NSOs without a liquidity plan

  • Confusing exercise with sale

Common NSO Questions (and Misconceptions):

Are NSOs taxed when they vest?

No. Vesting alone typically does not create a tax event. Exercise is usually the key tax trigger.
 

Do NSOs create ordinary income at exercise?

Yes. In most cases, exercising NSOs creates compensation income based on the spread, even if no shares are sold.
 

Do NSOs involve withholding and payroll taxes?

They can. Because NSO exercise income is treated like compensation, withholding and payroll taxes often apply.
 

Is exercise the same thing as selling?

No. Exercising is buying shares. Selling is disposing of shares you already own. These are separate events with different tax treatment.
 

Does an 83(b) election apply to NSOs?

Generally only in early-exercise situations with restricted shares. It does not apply to typical NSO exercise or sale timing.

How NSOs Fit Into the Bigger Decision:

NSOs are not about optimizing holding periods — they are about managing income timing, cash flow, and risk.

Key variables include:

  • When income is recognized

  • Whether withholding will be sufficient

  • Liquidity availability

  • Concentration in employer stock

For a decision-oriented framework that pulls these together, see When to Exercise Stock Options.

To Discuss your Equity Compensation and Wealth Management Needs:

Arc Element Wealth Design is a Nebraska-registered investment adviser. This material is provided for general educational and informational purposes only and does not constitute individualized financial, legal, or tax advice. Examples are simplified and may not reflect your specific circumstances. Investing involves risk. For full disclosures, visit:  Disclosures

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