Tax
NSO Exercise at a Private Company: Value, Withholding and Cash Due
Exercising nonqualified options at a private company triggers payroll tax on the spread. See how exercise-date value, withholding and W-2 reporting work.
By 409.AI Team - 2026-10-12
# NSO Exercise at a Private Company: Value, Withholding and Cash Due
An employee at a private company who exercises nonqualified stock options (NSOs) owes tax on the day of exercise, on shares they can't sell yet. The bill is calculated on a value nobody can look up, and the company has to withhold it through payroll. Finance leads and option holders who learn this at the moment of exercise usually learn it from a number they didn't plan for.
This guide walks through what gets taxed, which value sets the amount, what the company must withhold and report, and what an employee should have ready in cash before signing the exercise notice.
What the exercise itself triggers
An NSO has no tax event at grant when the option isn't actively traded, which is the usual case at a private company. Treasury's section 83 regulation says that for an option without a readily ascertainable fair market value, [sections 83(a) and 83(b) apply at the time the option is exercised or otherwise disposed of](https://www.law.cornell.edu/cfr/text/26/1.83-7). In plain terms, the tax clock starts at exercise.
The amount that counts as pay is the spread: the fair market value of the shares on the exercise date minus the exercise price. The IRS's W-2 instructions use exactly that wording for Box 12 Code V: [the spread, "that is, the fair market value (FMV) of stock over the exercise price,"](https://www.irs.gov/instructions/iw2w3) goes in Boxes 1, 3 (up to the Social Security wage base) and 5. The instruction covers a former employee's exercise too.
So the spread is ordinary wages. It carries income tax, Social Security and Medicare, just like a bonus.
Which value sets the spread
A public company reads the closing price. A private company has no price, so someone has to supply a fair market value for the exercise date.
No regulation names the 409A report as the measure of that value, and the section 83 and section 409A questions are different legal tests. In practice, most private companies use their current 409A valuation for both, because it is the independent, written support they already hold. That makes the age of the report a real issue.
The 409A regulation itself sets a useful standard. A previously calculated value [is not reasonable as of a later date](https://www.law.cornell.edu/cfr/text/26/1.409A-1) if it fails to reflect information available after the calculation that may materially affect the value, or if it was calculated for a date more than 12 months earlier. That language governs option pricing, not the exercise-date spread. But a finance team that applies it to exercises treats the two events consistently, and it gives an examiner no reason to ask why the exercise used an older standard.
Consider what that means after a priced round. Suppose the last 409A put common stock at $2.40, and three months later the company closes a Series B. An employee who exercises the week after the close with the old $2.40 figure would report a spread that the company's own board would struggle to defend. Our guide to [how often a company should refresh its 409A](https://www.409.ai/articles/409a-valuation-frequency-how-often-should-you-get-one) explains which events force a new report. The same events deserve a second look before any large exercise.
An exercise before the new report is ready has two reasonable paths. The company can ask its valuation provider for a bring-down to the exercise date, or it can hold large exercises until the new report lands, if the plan's terms and the employee's deadline allow. Which path fits is a call for the company's counsel and tax adviser.
A worked example
Take an engineer who holds 20,000 vested NSOs with a $1.20 exercise price. The company's current valuation, which still reflects its latest round, puts common stock at $4.50 on the exercise date. The engineer has earned $60,000 in wages so far this year.
| Item | Calculation | Amount | |---|---|---| | Spread (taxable wages) | 20,000 x ($4.50 - $1.20) | $66,000 | | Federal income tax withholding at the 22% supplemental rate | $66,000 x 22% | $14,520 | | Social Security, employee share | $66,000 x 6.2% | $4,092 | | Medicare, employee share | $66,000 x 1.45% | $957 | | Total withheld before any state tax | | $19,569 | | Cash to buy the shares | 20,000 x $1.20 | $24,000 | | Total cash due at exercise | | $43,569 |
Social Security tax stops at a wage base, which for 2026 is [$184,500](https://www.irs.gov/publications/p15). The engineer's $60,000 plus the $66,000 spread stays below it, so the whole spread bears the tax. State income tax and any local tax would come on top.
The company owes its own share too: another $4,092 in Social Security and $957 in Medicare, or $5,049, on the same spread. That cost is easy to miss in a budget because no payroll run produced it.
The 22% figure is a withholding rate, not the tax the engineer will owe. Pub. 15 describes it as [the flat rate an employer may use for supplemental wages](https://www.irs.gov/publications/p15), and the rate rises to 37% once an employee's supplemental wages from the company pass $1 million in the calendar year. An employee in a higher bracket can still owe more when the return is filed, which is why larger exercises often come with a note to adjust estimated payments.
What the company must do
The employer, not the employee, has the reporting and withholding duty.
First, it withholds federal income tax and employment taxes from the spread, and it deposits them on its normal schedule. A former employee who exercises inside a post-termination window creates the same payroll event, and the W-2 instructions say so.
Second, it reports the spread on the Form W-2 for the year of exercise, in Boxes 1, 3 and 5, and repeats it in Box 12 with Code V. W-2s are due to employees by January 31, so an exercise in December has to be entered in the right tax year, with the exercise date and value on record.
Third, it keeps the file. The file should hold the exercise notice, the exercise date, the valuation relied on and why it was current, and the payroll calculation. If an examiner asks how a private company chose a value on a date with no market, that file is the answer.
Where the cash comes from
The tax bill lands on a day when the employee receives shares, not cash. Several approaches exist, and the plan document decides which are available:
- The employee pays the exercise price and the withholding by check or wire at exercise.
- The company withholds the taxes from the employee's next paycheck, if the plan allows it and the amount is manageable.
- A net exercise or share withholding, where the company keeps some shares to cover cost and tax, if the plan permits it. The company then spends cash to remit the tax, which matters for a startup watching its runway.
Many private plans allow none of the share-based options, which leaves a cash payment. This is why exercising a large NSO grant at a company with no liquidity event in sight is often delayed until a tender offer or secondary sale supplies the cash. Our guide to [tender offers and secondary sales](https://www.409.ai/articles/tender-offers-secondary-sales-409a-valuation) covers how those events interact with the valuation.
How ISOs differ
Incentive stock options (ISOs) behave differently at exercise. Pub. 15-B states that [wages for Social Security, Medicare and FUTA purposes don't include remuneration from the exercise of an incentive stock option](https://www.irs.gov/publications/p15b). Employment taxes don't attach at an ISO exercise, but the spread can feed the alternative minimum tax. Our pieces on [ISO versus NSO taxation](https://www.409.ai/articles/iso-vs-nso-how-stock-options-are-taxed) and the [2026 AMT phase-out change for ISO exercises](https://www.409.ai/articles/iso-exercise-amt-2026-lower-phaseout-threshold) cover that path.
Some employees hold both types. The part of an ISO grant that exceeds the annual $100,000 limit is treated as an NSO, which means an exercise can produce a payroll event even from a grant that was meant to be incentive. The [ISO $100,000 limit explained against grant-date value](https://www.409.ai/articles/iso-100k-limit-409a-grant-date-fair-market-value) shows how the split happens.
Alternatives to paying tax at exercise
Two tools change the timing, and both need planning before the exercise date, not after.
An early exercise combined with an 83(b) election moves the tax event to a date when the spread is small, if the plan allows it. That matters for options that the company lets employees exercise before they vest. Our guide to [early exercise and the 83(b) election](https://www.409.ai/articles/early-exercise-stock-options-83b-election-iso-nso-qsbs) explains the 30-day filing window.
A qualified equity grant under section 83(i) can defer income inclusion for eligible employees of eligible companies, but it carries narrow conditions on who qualifies and on how the company grants. The guide to the [83(i) election](https://www.409.ai/articles/83i-election-qualified-equity-grant-tax-deferral) lists them.
A checklist before the exercise notice is signed
For the finance lead:
1. Confirm the option is an NSO, or the NSO portion of a mixed grant. 2. Pull the latest valuation and ask whether anything since its date would change the common stock value: a priced round, a tender, a term sheet, a large customer win or loss. 3. Decide the exercise-date value and write down the reason. 4. Run the withholding calculation, including the company's share of payroll tax. 5. Confirm how the employee will pay, and when the cash arrives. 6. Record the exercise for the correct W-2 year.
For the option holder, the questions are shorter. What will the value be on the exercise date, how much cash does the company need and by when, and does a 90-day window after leaving force the timing? If the answer to the last one is yes, read how companies [extend the post-termination exercise window](https://www.409.ai/articles/extending-post-termination-exercise-window-iso-nso-409a) before the clock runs out.
The takeaway
An NSO exercise at a private company is a payroll event priced by a valuation. The two numbers that decide how large the cash call is, the spread and the withholding, both rest on one question: what is the common stock worth on the day of exercise? Companies that keep a current, documented valuation answer it in minutes. Those that rely on a report from before the last round answer it under pressure, with an employee waiting. If your 409A is more than a few months old or predates a financing, a [409A valuation from 409.AI](https://www.409.ai/products/409a) starts at $899 and gives the exercise file a report it can point to.