What is a "nonqualified stock option"?
A nonqualified stock option, or NQSO, is a type of stock option that does not qualify for special favorable tax treatment under the US Internal Revenue Code. Thus the word "nonqualified" applies to the tax treatment (not to eligibility or any other consideration). NQSOs are the most common form of stock option and may be granted to employees, officers, directors, and consultants and other providers of goods and services.
With nonqualified stock options, companies have more flexibility than with incentive stock options (ISOs), which are "qualified" for favorable tax treatment under the Internal Revenue Code. Companies face fewer requirements in setting the exercise price of NQSOs and most of their other terms, though they need to be careful about granting discounted stock options. There are no statutory limits on the number of NQSOs that may be authorized under a stock option plan, though the number may be subject to limitation by shareholders concerned about the dilution of their ownership percentages.
When you exercise NQSOs, you recognize ordinary income on your W-2 for the exercise spread (i.e. the difference between the market price of the stock and your exercise price). Your company receives a corresponding tax deduction as long as it reports your income to the IRS. For more information on the taxation of NQSOs, see the section NQSOs: Taxes and the Tax Center.