The Startup Employee’s Tax Liabilities for Exercising NSOs

Non-qualified stock options (NSOs) are known for having less favorable tax rules and liabilities – therefore, if you’ve been granted NSOs, it’s especially important for you to understand all relevant tax liabilities before exercise. Luckily for you, despite their less favorable tax treatment, NSOs keep it simple and straightforward when it comes to taxes. 

But First, What Are NSOs?

NSOs are a type of stock option that can be granted by employers to both employees and outsourced service providers (i.e. freelancers, advisors, consultants, etc.). 

NSOs are called “non-qualified” stock options as they do not qualify for the more favorable tax benefits that incentive stock options (ISOs) receive. Due to this, NSOs can be subject to taxation on two occasions:
at exercise (when you purchase your shares) and when you eventually sell your shares. 

As we previously discussed, your grant letter should indicate an exercise deadline for your ISOs, usually in the form of a 90-day post-termination exercise (PTE) window.

While there is not a similar short-term exercise deadline for NSOs – as they can be exercised at any point before their long-term expiration date. – your company may include a limiting deadline. Be sure to check on this in your grant letter and with your employer’s HR team.

Also note that there are times when NSO holders are subject to taxation at the grant of their options. But unless you were subjected to paying taxes the moment you were granted your options, this does not apply to you. 

The $100K Limit

When an employee seeks to exercise ISOs valued at over $100,000, they are prevented from doing so – this is due to the “$100K ISO rule” or “$100K ISO limit.” 

In order to prevent tax abuse, the IRS only allows employees up to $100k of exercisable options from all grants to qualify as ISOs during a calendar year; any options beyond this amount are automatically considered NSOs. Due to this rule, employees must divide the exercisable ISOs from the remaining NSOs (generally referred to as an ISO/NSO split) before exercising. 

Due to the complexities of this rule – especially if you think your ISOs exceed the $100k limit – consult with a tax professional for further guidance and instruction. 

So, What Exactly Are These Rules and Liabilities for NSOs?

Remember, NSOs are subject to taxation on two occasions: after exercising your options and, later, when selling your shares. While non-qualified stock options are subject to alternative minimum tax (AMT) implications, there is no difference in amount for AMT and ordinary tax implications when it comes to NSOs. You will be responsible for paying ordinary income tax [1] and/or capital gains tax, depending on your actions after exercising. 

Taxable NSOs generally fall into one of these four categories: 

• Exercise your options and keep the shares. 
• Exercise your options and sell the shares on the same day. 
• Exercise your options and sell the shares within a year after purchasing. 
• Exercise your options and sell the shares more than a year after purchasing. 

Tax Implications at Exercise

Whether you exercise your options and hold onto your shares, sell your shares in a cashless exercise, or sell them at a later date, you will be subject to pay ordinary income tax on the spread of each option that you exercise. 

The spread is the difference between the fair market value at the time you are exercising your options and the exercise price (the amount paid for the stock on the date you were granted your NSOs). These numbers are typically included on your W2 from your employer. 

Again, the difference between these two numbers is considered taxable income. At a minimum, the FMV changes on an annual basis, so do take that into account when determining your spread.

Tax Implications After Selling Your Shares

The tax implications of selling your shares really depend on when you sell your shares after exercise. For example, if you complete a same-day sale, you will only be subject to pay income tax on your spread. 

However, if you decide to sell your shares within a year or more after purchase, you will pay ordinary income tax rates for the spread and be responsible for short-term or long-term capital gains tax rates, depending on your holding period. 

 Thanks for the Knowledge! Now What?

Now that you’ve expanded your understanding of your tax liabilities for exercising NSOs, let’s take all of this new information and apply it to our NSO decision tree. 

If you’ve already exercised your options, this interactive tool can help you explore your next steps. However, if you’re not at that stage in your financial journey quite yet, this tool will help you make a plan for when you do decide to exercise your stock options! 

[1] Ordinary income tax describes any type of income that is taxed at the United States’ marginal tax rates. This income includes wages, salaries, tips, and commissions. This term is also referred to interchangeably as regular income tax. See more in our glossary.