A nonqualified stock option (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.
Key facts to know about NQSOs:
- 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). Withholding occurs for taxes: federal, state (if applicable), Social Security, and Medicare.
- 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.
- NQSOs 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.
- With NQSOs, companies face fewer requirements in setting the exercise price and most of the other option terms (though they need to avoid 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 limits imposed by shareholders, who may be concerned about the dilution of their ownership percentages.
