What Is a Non-Qualified Stock Option (NSO), and How Is It Used?

What Is a Non-Qualified Stock Option (NSO)?

A non-qualified stock option (NSO) is a type of employee stock option wherein you pay ordinary income tax on the difference between the grant price and the price at which you exercise the option.

Breaking Down Non-Qualified Stock Option (NSO)

NSOs are simpler and more common than incentive stock options (ISOs). They are called non-qualified stock options because they do not meet all of the requirements of the Internal Revenue Code to be qualified as ISOs.

How Non-Qualified Stocks Are Used

Non-qualified stock options give employees the right, within a designated timeframe, to buy a set number of shares of their company’s shares at a preset price. It may be offered as an alternative form of compensation to workers and also as a means to encourage their loyalty with the company.

The price of these stock options is typically the same as the market value of the shares when the company makes such options available, also known as the grant date. Employees will have a deadline to exercise these options, known as the expiration date. If the date passes without the options being exercised, the employee would lose those options.

There is an expectation that the company’s share price will increase over time. That means employees stand potentially to acquire stock at a discount if the grant price—also known as the exercise price—is lower than later market prices. However, the employee will pay income tax against the difference with a market share price of the stock when the option is exercised. Once the options are exercised, the employee can choose to sell the shares immediately or retain them.

As with other types of stock options, non-qualified stock options can be a way to reduce the cash compensation that companies pay directly to their employees while also connecting part of their compensation to the growth of the companies. The terms of the options may require employees to wait a period of time for the options to vest. Furthermore, the employee could lose the options if they left the company before the stock options are vested. There might also be clawback provisions that allow the company to reclaim NSOs for a variety of reasons. This can include insolvency of the company or a buyout.

For smaller and younger businesses with limited resources, such options that can be offered in lieu of salary increases. They can also be used as a recruiting tool to make up for shortcomings in the salaries offered when hiring talent.