Which statement accurately describes Non-qualified Stock Options (NQSOs) tax treatment?

• A. They are taxed as ordinary income upon grant.
• B. They are taxed as ordinary income upon exercise, and the difference between strike price and market price is a company deduction.
• C. They are taxed as capital gains upon exercise.
• D. They are not taxed until sale.

Answer: (B)

NQSOs are taxed at exercise as ordinary income on the spread, which is the difference between the market price at exercise and the strike price. That amount is treated as compensation to you, so it appears on your W-2 and the employer can deduct the same amount as a compensation expense. There is no tax due at the grant date. When you eventually sell the shares, any additional gain or loss is a capital gain or loss, calculated using a basis that includes the exercise price plus the ordinary income recognized at exercise. If you hold the shares long enough after exercise, those gains are long-term; otherwise, they’re short-term. This contrasts with options that are taxed at grant or taxed only at sale, and it explains why the correct statement reflects ordinary income at exercise with the corresponding employer deduction, plus future capital gains treatment on sale.