Non-Qualified Stock Options (NSOs)
Stock options taxed as ordinary income on exercise, available to employees and contractors.
Definition
NSOs (also called NQSOs) are stock options that do not qualify for the favorable tax treatment of ISOs. The spread between the strike price and fair market value at exercise is taxed as ordinary income and subject to payroll taxes. NSOs can be granted to anyone, including contractors and advisors, and have no annual limit. Any options above the $100K ISO annual vesting limit are automatically treated as NSOs.
Why it matters
If you are a contractor, all your options are NSOs. Even as an employee, options vesting above $100K/year in value are NSOs. The tax bite is larger because the spread at exercise is taxed as ordinary income (up to 37%) rather than potential capital gains (20%).
Example
You exercise 10,000 NSOs at a $2 strike when FMV is $12. The $100K spread is taxed as ordinary income immediately. At a 37% bracket, you owe $37,000 in federal tax at exercise, regardless of whether you can sell the shares.