Definition:
A Non-Qualified Stock Option (NSO) is a type of stock compensation that can be provided to employees and other stakeholders, allowing them to purchase shares of their company at a predetermined price.
How Do Non-Qualified Stock Options Work?
A Non-Qualified Stock Option (NSO) is a type of stock compensation that can be provided to employees and other stakeholders. An NSO allows you the option to purchase your company’s stock at a predetermined price, which can be profitable if the stock price rises above this level. This price is known as the exercise price or strike price.
Example of NSOs:
For example, as an employee, you may receive stock options with an exercise price of $10 per share. If you have the option to purchase 100 shares, you can pay $1,000 to exercise those options at $10 per share.
If the stock price rises to $20 per share, you can exercise the options for $1,000 and then sell the 100 shares at $20 per share, or $2,000. You would make a profit of $1,000.
You can also hold onto the shares and hope for the price to rise further, making the stock options more profitable.
Tax Implications of Non-Qualified Stock Options
NSOs have some unique tax characteristics. Generally, you must pay ordinary income tax on the difference between the cost of exercising the options and the value of the options at the time you exercise them, even if you do not sell the shares immediately. So, as illustrated in the example above, it would be as if you received an additional $1,000 in income, and you must pay income tax on that.
Then, you will pay capital gains taxes if you hold onto the shares after exercising them and sell them for additional profit. For example, after exercising the options at $20 per share, let’s assume the stock rises to $30 per share. If you sell 100 shares at that price, you will pay capital gains taxes on the additional $1,000 in profits.
The capital gains taxes depend on how long you hold onto the shares. Long-term capital gains taxes are 0%, 15%, or 20%, depending on your income and whether you held the asset for over one year. Short-term capital gains occur when you hold an asset for less than one year. The rate is the same as the ordinary income tax rate.
Other Considerations for Non-Qualified Stock Options
NSOs work by granting employees or other stakeholders options to purchase shares of the company as part of a compensation package. The shares come with a specified exercise price.
Companies usually have a vesting period, where NSO recipients earn the right to exercise a greater percentage of their NSOs the longer they stay with the company. For example, after two years, you might vest 50% of your NSOs, meaning you can only take advantage of half of the options. You would fully vest after four years.
After vesting, you can decide when to exercise the options based on whether the company’s stock price rises above the exercise price. From here, the options become regular shares, which you can then act upon as you wish.
You should also consider any expiration date set by your company, as Non-Qualified Stock Options will become worthless if not exercised before the expiration date.
NSOs vs. ISOs
NSOs ISOs
Less restrictive (non-employees can receive these options) More restrictive (only employees can receive these options)
No special tax treatment qualifies for special tax treatment, but you must hold the shares for one year from the exercise date and two years from the grant date
It is
Taxes are imposed when exercised, and they are imposed when sold.
Higher taxes may be assessed, as taxes are imposed on profits at the time of exercising options at ordinary income tax rates. Lower taxes may be assessed, as all profits can be estimated at long-term capital gains rates, depending on the holding period.
Non-Qualified Stock Options (NSOs) are generally easier to provide by employers as they have fewer restrictions than Incentive Stock Options (ISOs), such as who can receive them and the value that can be exercised.
However, ISOs can be more tax-friendly, as all profits can be counted as long-term capital gains (depending on holding periods). In contrast, with NSOs, the difference between the exercise price and the fair market value at the time of exercise can be taxed as ordinary income tax.
Frequently Asked Questions (FAQs)
How are Non-Qualified Stock Options taxed?
Upon exercising your non-qualified stock options, you will pay ordinary income tax (state and federal) on the value between the fair market value and the grant price. You will also pay taxes on any capital gain once you sell your stock.
What does it mean when a stock option is non-qualified?
When a stock option is non-qualified, it means that the stock option does not meet certain requirements set by the IRS for special tax treatment (such as incentive stock options). With NSOs, you pay taxes when exercising the option and when selling the stock.
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Sources:
Schwab. “Stock Options.”
Turbotax. “Non-Qualified Stock Options.”
Morgan Stanley. “Non-Qualified Stock Option Basics.”
IRS. “Topic No. 409 Capital Gains and Losses.”
Fidelity. “FAQs – Stock Options.”
Fidelity. “About Stock Options.”
Source: https://www.thebalancemoney.com/what-is-a-non-qualified-stock-option-nso-5213940
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