How Are Non-Qualified Stock Options Taxed?

Non-Qualified Stock Options (NSOs) are a common form of equity compensation. These options grant an individual the right to purchase company shares at a predetermined exercise price within a defined timeframe. NSOs differ from other stock options, such as Incentive Stock Options (ISOs), because they do not qualify for certain preferential tax treatments. This distinction impacts when and how NSO income is taxed, making understanding the implications important for recipients.

Taxation When Exercising NSOs

The primary tax event for NSOs occurs at the time of exercise, when the option holder chooses to purchase company shares at the exercise price. At this point, the difference between the fair market value (FMV) of the stock on the exercise date and the lower exercise price is immediately recognized as taxable income. This difference is commonly referred to as the “bargain element” or “spread.”

This bargain element is treated as ordinary income, similar to wages or salary. Consequently, it is subject to federal income tax at regular marginal rates, and also to Social Security and Medicare taxes, collectively known as FICA taxes. For employees, the employer is generally responsible for withholding these taxes.

The amount of the bargain element and the taxes withheld are typically reported on the individual’s Form W-2 for the tax year in which the options were exercised. Specifically, the ordinary income from the NSO exercise may be included in Box 1 of Form W-2 and often detailed in Box 12 with Code V.

Individuals can use various methods to exercise NSOs. A common approach is a “cash exercise,” where the individual uses their own funds to pay the exercise price and cover the associated taxes. Alternatively, a “cashless exercise” or “sell-to-cover” method allows the individual to exercise their options without using out-of-pocket cash. In a cashless exercise, a portion of the newly acquired shares is immediately sold to cover the exercise price, withholding taxes, and any brokerage fees. While this method offers convenience, the tax event still occurs at exercise, and the bargain element remains taxable as ordinary income.

Taxation When Selling NSO Shares

After exercising NSOs and acquiring the underlying company shares, a second tax event occurs when those shares are sold. This sale triggers capital gains or losses, depending on the sale price relative to the shares’ adjusted cost basis.

The cost basis for capital gains is calculated as the sum of the exercise price paid for the shares and the ordinary income (bargain element) recognized at exercise. This means that the amount already taxed as ordinary income at exercise is added to the initial purchase price to establish the basis. For example, if shares were exercised at $10 when the fair market value was $50, the $40 bargain element per share would be added to the $10 exercise price, resulting in a cost basis of $50 per share. Any further appreciation or depreciation in the share price from this adjusted cost basis will result in a capital gain or loss upon sale.

The taxation of this capital gain or loss depends on the holding period of the shares after the exercise date. If shares are held for one year or less from the exercise date before being sold, any gain is a short-term capital gain. Short-term capital gains are taxed at the individual’s ordinary income tax rates.

Conversely, if shares are held for more than one year after the exercise date before being sold, any gain is classified as a long-term capital gain. Long-term capital gains typically receive preferential tax treatment, with lower tax rates than ordinary income rates. For tax year 2025, long-term capital gains are generally taxed at 0%, 15%, or 20%, depending on the taxpayer’s taxable income and filing status. If shares are sold for less than their adjusted cost basis, a capital loss occurs, which can be used to offset other capital gains and, to a limited extent, ordinary income.

Reporting NSO Income and Sales

The ordinary income recognized at NSO exercise is reported by the employer. This amount, which constitutes the bargain element, is included in the individual’s gross wages and reported on Form W-2. This ensures that federal income tax, Social Security, and Medicare taxes are properly accounted for and withheld by the employer.

When shares acquired through NSO exercise are later sold, the brokerage firm reports the transaction. The broker issues Form 1099-B, “Proceeds From Broker and Barter Exchange Transactions,” to the individual and the IRS. This form details the gross proceeds from the sale and may also report the cost basis of the shares. Individuals should verify the cost basis reported on Form 1099-B.

Often, the cost basis reported by the broker on Form 1099-B may not reflect the full adjusted cost basis that includes the ordinary income recognized at exercise. If the basis is understated on Form 1099-B, it is the taxpayer’s responsibility to correct it when filing their tax return to avoid overpaying capital gains tax. This correction is typically made on Form 8949, “Sales and Other Dispositions of Capital Assets.”

Form 8949 is used to list the details of each capital asset sale, including the proceeds and the correct cost basis. The totals from Form 8949 are then carried over to Schedule D, “Capital Gains and Losses,” of the taxpayer’s Form 1040. Schedule D summarizes all capital gains and losses for the year, distinguishing between short-term and long-term transactions, and calculates the net capital gain or loss.