Understanding Non qualified Stock Options (NSO) for a USA based startup

Non-Qualified Stock Options (NSOs) are one of the most popular ways for U.S.-based startups to incentivize their teams. While they are similar to Incentive Stock Options (ISOs), NSOs come with a lot more flexibility in terms of who can receive them and how they are taxed. In this blog, we’ll break down what makes NSOs special, how they’re taxed, and what you need to know if you’re considering exercising or selling them.

1. Who Can Get NSOs?

One of the best things about NSOs is the flexibility they offer in terms of who can receive them. Unlike ISOs, which can only be granted to employees, NSOs can be given to:

• Employees
• Directors
• Advisors
• Mentors
• Consultants
• Contractors (both in the U.S. and abroad)

This flexibility makes NSOs especially attractive for startups that want to reward a broader group of people who are helping to grow the business, whether they’re full-time employees or part-time consultants.

2. How Are NSOs Taxed When You Exercise?

When you exercise your NSOs, you’ll need to pay taxes on the difference between the market price of the stock and the exercise price. This is considered ordinary income and will be taxed at your usual income tax rate.

For example, if the fair market value of the stock is $20 per share when you exercise and your exercise price is $10, you’ll pay income tax on the $10 difference. It’s important to plan ahead because that tax bill could be significant, depending on how much stock you’re exercising.

3. What Happens When You Sell the Stock?

Once you’ve exercised your options and hold onto the shares, the tax treatment when you sell the stock will depend on how long you’ve held it.

Short-Term vs. Long-Term Capital Gains

If you sell the stock within one year of exercising, the profit will be taxed as short-term capital gains at your regular income tax rate, which is usually higher than the long-term capital gains tax rate. But if you wait longer than a year to sell, you’ll pay long-term capital gains tax, which is generally more favorable (lower) than ordinary income tax.

Knowing when to sell can make a big difference in how much you pay in taxes, so it’s worth paying attention to how long you’ve held onto the stock before deciding to sell.

4. What About International Employees and Contractors?

If you have international employees, consultants, or contractors, things can get a bit more complicated. U.S. tax laws primarily apply to U.S. taxpayers, but foreign tax laws can differ significantly. Depending on the country, the tax treatment of NSOs might be different, and you’ll want to understand those rules before making any decisions. So, if you’re dealing with team members outside the U.S., it’s crucial to check out the local tax regulations.

Conclusion

Non-Qualified Stock Options (NSOs) are a flexible and powerful tool for U.S.-based startups to attract and reward talent. While they come with specific tax rules — like paying ordinary income tax at exercise and capital gains tax on the sale — understanding these nuances can help you make smarter decisions about when to exercise or sell your stock.

Before you act, consider the impact of the holding period on capital gains and the taxes you’ll owe. And if you're dealing with international team members, always check the local tax laws to make sure everything is set up properly.

For more tips on managing your stock options and optimizing tax strategies, check out our latest video. We dive into real-world examples and share expert advice to help you navigate the world of NSOs.