NSO Exercise Tax Guide
Ordinary income at exercise, withholding mechanics, basis tracking, and what changes at the later sale.
Last updated: January 2026
NSO tax treatment overview
Non-qualified stock options (NSOs) are simpler than ISOs, but often more costly: the spread is taxed as ordinary income at exercise, regardless of whether shares are sold.
| Event | Tax treatment | Withholding required? |
|---|---|---|
| Grant | No tax event | No |
| Vesting | No tax event | No |
| Exercise | Ordinary income on spread | Yes — mandatory |
| Sale (< 1 year) | Short-term capital gain/loss | No |
| Sale (≥ 1 year) | Long-term capital gain/loss | No |
Taxation at exercise
At exercise, the spread (FMV − strike) is treated as compensation income and is subject to federal and state withholding.
- Reported on Form W-2 in the year of exercise
- Subject to Social Security and Medicare (including surtaxes)
- State withholding varies by state and employer payroll treatment
Federal supplemental wage withholding is often 22% (37% above $1M). Clients in the 32–37% brackets may be under-withheld and face a tax bill at filing.
Withholding methods
| Method | Description |
|---|---|
| Sell-to-cover | Broker sells enough shares to cover taxes; employee keeps remainder |
| Cash payment | Employee pays cash to employer/broker for withholding |
| Net share settlement | Employer withholds shares equal to the tax obligation |
| Payroll offset | Withholding deducted from regular paycheck (if sufficient) |
Cost basis for later sale
After exercising NSOs, the cost basis becomes:
Cost basis = Strike price + Ordinary income recognized at exercise
Example: exercise and later sale
| Transaction | Amount | Tax treatment |
|---|---|---|
| Strike price | $10/share | — |
| FMV at exercise | $40/share | — |
| Shares exercised | 1,000 | — |
| Ordinary income at exercise | $30,000 (1,000 × $30 spread) | Taxed as wages + FICA |
| Cost basis in shares | $40,000 (1,000 × $40) | — |
| Sale price (2 years later) | $60/share | — |
| Capital gain | $20,000 ($60K − $40K) | LTCG if held > 1 year |
NSO vs. ISO quick comparison
| Factor | NSO | ISO |
|---|---|---|
| Tax at exercise | Ordinary income on spread | No regular tax (AMT adjustment possible) |
| Withholding at exercise | Required | Not required |
| FICA taxes | Yes, on spread | No |
| Holding period benefit | LTCG only on post-exercise appreciation | LTCG on entire gain if qualifying |
For clients with both NSOs and ISOs, prioritize ISO exercises when AMT can be managed — NSO ordinary income provides no path to capital gains treatment on the spread.