Nonqualified stock options (NSOs) are "nonqualified" in the sense that they do not meet the requirements of §422. Unlike incentive stock options, the holder will realize ordinary income upon exercise equal to the excess of the fair market value of the stock received (as of the date such stock is free of substantial risk of forfeiture or becomes transferable, according to §83 of the Code) over the value of the consideration paid. Without incurring cash expense, the employer will be entitled to a business-expense deduction equal to the amount of compensation taxable to the employee. The holder's compensation is not a tax-preference item for purposes of the alternative minimum tax. The employer will have a charge against its earnings if, as of the date of grant, the fair market value of the shares subject to the option exceeds the exercise price.
With the advent of Internal Revenue Code Section 409A, non-qualified stock options are no longer issued if the exercise price is below fair market value. See employee options, ISOs and NSOs or Non-Quals, must be issued at exercise prices equivalent to fair value. Incentive stock options become NSOs if, as often happens, the grantee elects to exercise and sell contemporaneously, "cashless exercise," because he does not want the risk of a one year hold.