So you want to learn about non-qualified stock options, huh? You’ve come to the right place. Here we’ll break down what a non-qualified stock option is and how it works, including when and why they are offered and how they differ from other stock options.
non-qualified stock options are typically part of an employee’s total compensation package. Organizations that offer them hope to incentivize their employees for their hard work and dedication. If you’re reading this article, chances are you have been offered non-qualified stock options or are considering offering them at your organization.
Knowing the details will help you decide smartly about these stock options and maximize the investment.
Let’s get started!
What Is a Non-Qualified Stock Option (NSO)?
A non-qualified Stock Option (NSO) is a financial instrument employers use to recruit, reward, and retain employee talent. This option gives employees the right to buy a predetermined number of shares at a fixed price for a limited period of time.
NSOs attract employers because they allow them to motivate employees without giving away equity or tying up cash flow. They also allow startup companies to attract talent without giving out company shares since the option does not need to be exercised until later.
On the other hand, employees benefit from this instrument because it allows them to purchase shares in their own company at a discounted price (if they choose to exercise their NSO). This also gives employees a sense of ownership and commitment toward their employer’s success.
Overall, non-qualified Stock Options are an effective way for employers and employees to benefit from an agreement that suits both parties.
Understanding the Basics of Non-Qualified Stock Options
Non-qualified stock options (NSOs) are those granted to employees who can purchase company stock at a predetermined exercise price. The main difference between NSOs and other stock options (such as incentive stock options) is that the former are not eligible for special taxation treatment.
So what are the basics of NSOs? Here’s an overview:
- They allow employees to purchase company shares at a predetermined, discounted price.
- They can only be exercised after a set vesting date, meaning you must wait before accessing them.
- They are subject to ordinary income tax on the difference between the exercise and market prices when the options are exercised.
- Any profits from selling NSO shares may be subject to capital gains taxes, depending on how long the employee has held them.
With this information, you can now decide whether this investment opportunity is right for you.
What Are the Tax Implications?
Regarding taxes, non-qualified stock options (NSOs) have some unique considerations. When you buy an NSO, the strike price is established, but the amount of income you’ll have to report to the IRS isn’t finalized until you sell or “exercise” your option.
At that point, the income subject to taxation is calculated by subtracting your option’s strike price from the stock’s fair market value. This difference is then considered compensation and taxed as ordinary income according to your tax bracket.
If you hold on to an NSO for more than one year after it’s been exercised, any subsequent gains or losses are classified as capital gains or losses by the IRS and taxed accordingly. The holding period begins on the day after exercise—it does not include the day of exercise itself.
These tax implications may be considered when deciding whether to exercise an NSO. If you exercise, consider using a broker or tax software like TurboTax® Self-Employed to ensure everything is handled correctly and complies with IRS regulations.
How Do Non-Qualified Stock Options Compare to Incentive Stock Options?
You may be asking, how does a non-qualified stock option compare to an incentive stock option? Let’s take a look.
The primary difference between the two types of options is that incentive stock options are qualified for special tax treatment, while non-qualified stock options are not. With an incentive stock option, you can purchase the company’s stock at a discounted price and be taxed only when you sell it. However, with a non-qualified stock option, you’ll pay taxes on the difference between the price you paid for the stock and its fair market value when it’s purchased.
Non-qualified options offer some tax advantages compared to other forms of compensation. If the option is held for more than one year before being exercised, any resulting income or gains can qualify for capital gains tax rates instead of ordinary income.
In addition, employers may receive a tax deduction for any fees associated with granting non-qualified options. This can make them a more attractive option for companies looking to reward employees without taking too much of a hit on their own finances.
The liquidity of non-qualified options is also greater than that of incentive stock options because they do not have to comply with certain rules and regulations related to restricted securities or insider trading laws. This means that employees and investors have an easier time selling off their stocks at their discretion once they have owned them for a period of time, which can be beneficial if they need cash quickly or want to diversify their portfolios.
How Are Non-Qualified Stock Options Awarded?
So, now you know what a non-qualified stock option is. But how exactly are these types of stock options awarded?
non-qualified stock options are usually given as part of an employee compensation package. Employees often get stock options to incentivize them to stay with the company, hoping they’ll benefit from the company’s growth in the future.
Companies will also specify certain vesting periods within this employee compensation package. This helps to ensure that employees stick around for varying lengths of time so that they can reap the benefits from their stock options—in other words, it incentivizes long-term staying power!
Employees can also purchase and sell non-qualified stock options on their own terms. They do so by executing an agreement with their employer, agreeing that they will not be able to sell the options until after a certain amount of time (or some other specific conditions have been met). Upon expiration or sale of their option and fulfilling any other requirements, they may receive cash or stock payment, depending on their choice.
Using Non-Qualified Stock Options
If you’re interested in using non-qualified stock options, the first step is to select a broker to help you execute your trades. Your broker should be able to help you understand the terms of the option and explain the fees associated with exercising the option.
Once you know the basics, here are some of the steps involved in executing a non-qualified stock option:
- Research and decide which options are best suited to your needs.
- Place an order with your broker and understand all associated fees clearly.
- Monitor the investment to determine when it makes sense to exercise your option.
- When it’s time to exercise, contact your broker immediately—it’s important to ensure this happens within certain timelines to not lose out on profits or risk paying additional taxes or penalties.
- After exercising, you can then decide whether or not to keep or sell the shares acquired through exercising your stock options.
This process is relatively straightforward but requires careful consideration as any missteps can have dire consequences for profits—so make sure you work with a qualified broker who can provide expert advice and help guide you through each step of this process for maximum success!
What Should You Consider Before Exercising Your Non-Qualified Stock Options?
Before exercising your non-qualified stock options, consider a few things.
When you exercise your NSOs, you will incur taxes on the amount the stock has appreciated since the option was granted. This is known as the “spread” or the “bargain element.” So if your non-qualified stock option was granted at $10 per share and is now at $20 per share, when you exercise your option, the spread between the two numbers ($10) will be taxed as ordinary income by the IRS.
Incentive Stock Options vs. Non-Qualified Stock Options
It’s important to note that non-qualified stock options differ from incentive stock options (ISOs). ISOs aren’t taxed until you sell them, and any capital gains taxes due will be based on long or short-term rates. However, any gains made on NSOs are taxed as ordinary income when the options are exercised.
Holding Shares After Exercise
You may often want to hold onto some or all of your shares after exercising your options — this is something else to consider before making a move. Hold onto those shares for more than one year after exercising them. You can avoid paying short-term capital gains taxes on the spread and instead pay long-term capital gains taxes — no matter how quickly those shares appreciate in value after exercise. This can save you a lot of money in taxes — so it’s important to factor it into your decision-making process.
What Happens After You Exercise Your Non-Qualified Stock Option?
So, now that you know what a non-qualified stock option is, what happens after you exercise your option?
Once employees have exercised their NSO, they can do two things. They can either choose to hold the shares for a period of time or sell them immediately.
If the employee chooses to hold the shares, they typically need to wait at least one year from the date of purchase to sell them to qualify for capital gains tax treatment and receive long-term tax benefits. Additionally, depending on their employer’s plan rules, certain restrictions, such as a vesting period, may be required before the shares can be sold.
Alternatively, if an employee exercises their NSO and sells the shares immediately, they will be treated as ordinary income and taxed at the employee’s ordinary income tax rate. This is why exercising an NSO and holding the shares for at least one year is usually preferable.
In either case, employees must document any proceeds from selling non-qualified stock options on their taxes and provide a copy of Form 1099-B, which outlines all proceeds generated by the sale of stocks.
You might wonder what it means to “exercise” your stock options. This is the process of cashing out your non-qualified stock options when you decide to do so.
When you exercise your options, you agree with the issuer of your stock option and pay the agreed-upon price in cash or shares for the underlying stock. The issuer usually sets this price at either the fair market value or a fixed price determined at the grant date.
The exercise date is also important—you must exercise your options within a certain time limit specified in the terms and conditions of your option grant. Once you have exercised your options, they are considered vested, meaning that you own those shares and can do whatever you want with them—including keeping them, selling them, or trading them.
So if someone offers to buy your vested shares, all you have to do is complete all necessary paperwork and collect the cash in exchange for those shares. It’s as simple as that!
Learn how to do a cashless stock option exercise here.
NSOs vs. ISOs
Another thing to note when looking at non-qualified stock options is the difference between NSO and ISO, which stands for incentive stock option. Although they work similarly in allowing you to purchase stocks at a price lower than the current market rate, ISOs have some special tax advantages that NSOs don’t.
With an ISO, you can avoid paying taxes on the income from the options when the stock is sold. When you sell your shares from an ISO, any profit is treated as a long-term capital gain, which usually has a much lower tax rate than income earned with an NSO.
You must meet certain requirements to be eligible for an ISO rather than an NSO. You must hold onto the stocks for at least one year after exercising the option and two years after it was granted before you’re eligible for this tax benefit. You’ll also need to stay employed with the company that granted these options during this period for them to be classified as ISOs rather than NSOs.
In short, non-qualified stock options are typically less advantageous from a tax perspective than incentive stock options which gives employees extra incentive (pun intended!) to look into how they can qualify for an ISO instead of getting stuck with an NSO.
Employee Stock Purchase Plan
Many companies offer an employee stock purchase plan (ESPP) program that allows employees to purchase shares of company stock at a discounted price. Typically, an ESPP will offer employees an option to purchase stock at a set price, known as the exercise price, which is typically lower than the stock’s current market price. This option to purchase the stock is known as a stock option.
The value of the stock options can increase if the stock price rises above the exercise price, allowing employees to sell the stock for a profit. On the other hand, if the stock price falls, employees may choose to hold onto the stock in hopes that it will increase in value. Alternatively, they may choose to sell the stock and take the loss.
When employees exercise those options and buy the stock, they must pay ordinary income tax on the difference between the exercise price and the stock’s current market price. This difference is known as the bargain element. Employees’ profit is subject to capital gains tax if they sell the stock. Non-qualified stock options give employees the right to buy the stock at a set price but do not have an expiration date.
One of the benefits of an ESPP is that employees can purchase shares of company stock at a discount. In addition, some employers allow employees to take a tax deduction for the amount of the bargain element they paid for the stock. However, it is important for employees to carefully consider the risks involved in purchasing company stock, as the value of the stock can fluctuate greatly over time. Moreover, exercising options to buy company stock will result in taxable income in the year you exercise the options.
You might still have questions about non-qualified stock options, so let’s dive into some common Frequently Asked Questions (FAQs).
What Is the Difference Between a Qualified Stock Option and a non-qualified Stock Option?
The main difference is that you can get tax breaks when you exercise a qualified stock option, whereas you can’t go with a non-qualified stock option. A qualified stock option is eligible for preferential income tax treatment, while non-qualified stock options don’t receive any special tax treatment.
What Happens When I Exercise a non-qualified Stock Option?
When you exercise a non-qualified stock option, the ordinary income is equal to the difference between the market value of the underlying shares on the exercise date and the grant price. This amount is subject to income taxes at your ordinary income rate and may also be subject to payroll taxes. This means you should plan your finances carefully when exercising your options.
How Long Do I Have to Exercise My non-qualified Stock Options?
non-qualified stock options typically expire 10 years after being granted, although this may vary among companies. Check with your employer how long you must exercise your non-qualified stock options.
In summary, non-qualified stock options are a great way to incentivize employees, but they come with rules and regulations. Before supporting them in your organization, understand the basics of these options and the tax implications and other risks.
Overall, non-qualified stock options are a great way to allow employees to purchase company shares at a discounted rate while still maintaining the value of their compensation. If properly structured, they can be a mutually beneficial arrangement for employers and employees alike.