NSOs Explained

What is an NSO

A nonqualified stock option gives you the right to purchase shares of company stock at a fixed price, known as the exercise price or strike price, that is set at the time the option is granted. If the stock appreciates after the grant date, you can still buy shares at the original lower price.

The difference between the exercise price and the fair market value of the stock at the time you exercise is called the spread, or bargain element. With NSOs, that spread is generally treated as ordinary compensation income in the year of exercise.

What happens at exercise

Exercising an NSO typically creates a taxable event in the year of exercise. The spread is generally recognized as ordinary income at that point and is usually subject to withholding.

After exercise: sell or hold

If you sell shares immediately after exercise, the spread is recognized as ordinary income and there is typically little or no separate capital gains result, depending on the timing of the sale.

If you hold the shares after exercise, future appreciation above the exercise-date value is generally treated as a capital gain, long-term if the shares are held more than one year from exercise, short-term if not. Holding also means carrying market risk and company concentration on a position where ordinary income has already been recognized.

Where the planning gets more involved

For smaller exercises the decision can be straightforward. As the spread gets larger, several things tend to converge: a meaningful ordinary income event, withholding that may or may not cover the full tax liability, a decision about whether to hold shares afterward, and the question of how much company stock exposure already exists in the rest of the portfolio.

The tax result is only the first layer. The decisions about how much to exercise, whether to hold anything afterward, and how that fits the rest of your financial picture are where the real planning begins.