How Are NQOs Taxed When Sold, and What Capital Gains Rates Apply?

Non-Qualified Stock Options (NQOs) are a popular form of equity compensation, especially in tech companies and startups. While most people understand that NQOs are taxed at exercise, the tax treatment doesn’t stop there. How and when you sell the shares acquired through NQOs can significantly impact your overall tax liability—particularly in terms of capital gains.

Step 1: Ordinary Income Tax at Exercise

Before diving into how NQOs are taxed when sold, it’s important to recap the first tax event. When you exercise NQOs, the spread between the exercise price and the fair market value (FMV) at the time of exercise is taxed as ordinary income. This income is reported on your W-2 and is subject to income tax, Social Security, and Medicare.

Once the shares are exercised and the initial income is taxed, the next step—selling the shares—can trigger additional taxes in the form of capital gains.

Step 2: Capital Gains Tax at Sale

The tax you owe when selling NQO shares depends on how long you’ve held them after exercising:

• Held for one year or less: Any profit from the sale is taxed at short-term capital gains rates, which are the same as your ordinary income tax rate (up to 37% federally).
• Held for more than one year: The gain qualifies for long-term capital gains treatment, with federal rates typically ranging from 15% to 20%, depending on your taxable income. High earners may also be subject to a 3.8% Net Investment Income Tax.

For example, if you exercised NQOs at $10/share when the FMV was $30/share and later sold them at $50/share, you would:

1. Pay ordinary income tax on the $20 spread at exercise.
2. Pay capital gains tax on the additional $20 gain at sale. If you held the shares for more than one year post-exercise, this would be taxed at long-term rates.

Key Takeaways

• NQOs create ordinary income tax liability at exercise.
• Additional gains at sale are taxed as capital gains—short-term if held less than one year, long-term if held more than one year.

Timing your sale strategically can reduce your tax bill and maximize after-tax returns.