There are two types of stock options: incentive stock options (ISOs) and non-statutory stock options (NSOs).

ISOs are generally what come to mind when people think of stock options, but NSOs are also common. How you approach each is slightly different.

What are NSOs?

NSOs are typically used by more mature companies for higher-paid employees. These stock options are also given to contractors, consultants and other non-employees if companies want to give them more than $100,000 worth of stock annually.

Because NSOs do not meet the requirements of IRS Code Section 422, they do not benefit from the (potential) corresponding tax benefits that ISOs benefit from.

NSOs vs. ISOs

The main difference is between NSOs and ISOs is how they are taxed.

Tax treatment of NSOs

Typically, NSOs are taxed at the date of exercise rather than the date of grant.

The amount subject to ordinary income tax is the difference between the fair market value (FMV) at the time of exercise and the strike price. If you continue to hold the stock after exercise, any gain in price is subject to capital gains rules.

For example, let’s say:

• You are granted 300 shares of XYZ, Inc., on January 1 with an exercise price of $10 per share and 100 shares vesting each year for the next three years.
• After the first year, you exercise 100 vested shares when the FMV is $30. The amount reported as ordinary income is $2,000.
• Let’s say you hold the stock for one more year and sell when the FMV is $42. The amount subject to capital gains tax then is $1,200.

NSOs are subject to ordinary income tax and reported as W-2 wages for employees. They are also subject to federal and state income taxes as well as Social Security and Medicare taxes.

Exercising and selling NSOs

There is no hard-and-fast rule when it comes to exercising and selling NSOs, but it’s generally a good idea to have more aggressive diversification if they are deep in the money (~33%-plus) and there is no special reason to defer income.

In general, it’s a good idea to not let in-the-money options expire.

Our take: Diversifying after exercising NSOs

Since NSOs are taxed as ordinary income upon exercise, we generally recommend diversifying right away if you are deep in the money and there is no special reason to defer income (rather than holding and hoping the stock goes up).

If you exercised shares in the past and now hold a material amount of stock, it can often make sense to start diversifying. It’s usually good to start with the highest-cost, long-term lots first. The amount to sell will likely come down to how much you’re comfortable with.

Consider consulting a tax advisor and a financial professional to learn more.