Day 3: NSOs – The Good, the Bad, and the Taxes

Understanding the Tax Implications of Stock Options

Day 3: NSOs – The Good, the Bad, and the Taxes

Non-Qualified Stock Options (NSOs) are the most common type of stock option offered to employees, executives, and consultants. Unlike ISOs, NSOs do not receive special tax treatment, which means higher tax liability—but also more flexibility.

Today, we’ll break down how NSOs are taxed, when to exercise, and how to minimize your tax bill.

How NSOs Are Taxed

NSOs have two taxable events:

1️⃣ At Exercise – You pay ordinary income tax on the “spread” (the difference between the fair market value (FMV) and the grant price).

2️⃣ At Sale – You pay capital gains tax on any increase in value from the FMV at exercise.

💡 Example:

• Alex receives 10,000 NSOs at $5 per share.

• The stock rises to $20, and he exercises.

• The spread is $150,000 (10,000 shares × ($20 - $5)).

• That $150,000 is W-2 income, subject to income tax + payroll taxes.

• If Alex later sells at $30 per share, the additional $100,000 gain is capital gains tax.

📌 Cited in IRC: NSOs are taxed under IRC § 83 (compensation income) and IRC § 409A (deferred compensation rules).

Why NSOs Can Be a Tax Trap

🚨 Biggest mistake: Exercising NSOs without selling and failing to plan for the tax bill.

⚠️ NSOs trigger tax at exercise, even if you don’t sell – Unlike ISOs, which may only trigger AMT, NSOs immediately create taxable income when exercised.

⚠️ Payroll taxes apply – Unlike ISOs, NSOs are subject to Social Security and Medicare taxes (FICA).

💡 Example of a Bad Tax Move:

• Mia exercises 50,000 NSOs when the stock is $100 per share (strike price $10).

• She owes tax on $4.5 million in compensation income, but the stock drops to $50 per share before she sells.

• She’s stuck with a massive tax bill on money she never actually saw.

📌 Lesson: If your stock is illiquid, be careful about exercising NSOs unless you can sell shares immediately to cover taxes.

Smart Strategies to Reduce NSO Taxes

✅ Exercise and Sell Immediately (Same-Day Sale) – This avoids risk of the stock price dropping and covers tax liabilities upfront.

✅ Sell Some Shares to Cover Taxes (Cashless Exercise) – Many companies allow you to automatically sell a portion of shares to cover taxes, reducing out-of-pocket costs.

✅ Hold for Long-Term Capital Gains – If you exercise and hold for a year, you can convert future gains from ordinary income (37% tax) to long-term capital gains (15-20%).

✅ Time Exercises in Lower-Income Years – If you expect a bonus or job change, consider exercising in a low-tax year.

Tomorrow’s Topic: RSUs – How to Avoid Tax Shock When They Vest

Restricted Stock Units (RSUs) are simpler than stock options, but they trigger huge tax bills at vesting—even if you don’t sell! Tomorrow, we’ll cover:

✔️ Why RSUs are taxed as W-2 income

✔️ How to plan for your RSU tax bill in advance

✔️ Strategies to minimize RSU taxes

Got questions? Drop them in the comments or message me!