In what manner are nonqualified stock options typically taxed?

Nonqualified stock options (NSOs) are typically taxed as ordinary income upon exercise. This means that when an employee exercises their stock options—i.e., when they choose to buy the stock at the predetermined option price—they realize ordinary income equal to the difference between the market price of the stock and the option price at the time of exercise. This income is subject to income tax and payroll taxes, similar to wages.

The immediate taxation occurs because the exercise of nonqualified options is considered a compensatory benefit. This is in contrast to qualified stock options, where tax implications may be different and can often be deferred. After exercise, if the employee decides to sell the stock later, any further appreciation in the stock's value from the time of exercise until the time of sale may be taxed as a capital gain.

Understanding this tax treatment is crucial for employees and financial advisors, as it influences decisions regarding the timing and strategy of exercising stock options and managing their tax liability.