What are Non-qualified Stock Options?
Non-qualified stock options, typically known as NSQOs or NSOs, are options to buy a company’s shares at a preset price for a specific period of time.
Stock options are often used as a way to attract talent and encourage employees to stay with a company. They are a form of long-term incentive compensation, which is a popular way for high-earning executives and employees to be rewarded. There are two types of stock options: non-qualified stock options and incentive stock options.
Non-qualified stock options are similar to stock options that are issued to employees of a company, with a few distinct differences. Unlike with incentive stock options (ISOs), where you don’t pay taxes upon exercise, with NSOs you pay taxes both when you exercise the option (purchase shares) and sell those shares. This usually means you pay more taxes when dealing with NSOs.
However, the recipients of non-qualified stock options have no rights as shareholders until the options are exercised.
Let us try to understand this in detail.
What is a Stock Option?
A stock option is a legal contract between two parties, by which the buyer acquires the right, but not the obligation, to buy or sell an agreed amount of a specified underlying asset at a predetermined price (the strike price) at any time during a specified period of time (until the expiration date).
Usually, the price is based on what the shares are worth when the options are granted, or the fair market value. Depending on how much the share's value increases over time, you may be able to make money on the difference between your fixed purchase price and your eventual sale price.
When can I exercise non-qualified stock options?
As part of company compensation packages, companies often offer stock options to attract top candidates. These options are called non-qualified stock options. In general, there are 2 different types of exercise restrictions on a non-qualified stock option: time-based and performance-based.
Time-based restrictions mean that an employee can only exercise the option if they have been working for over a certain period of time after being granted the option.
A person generally cannot buy all of their shares right away and must work for the company over time to be able to do so. This is known as vesting.
Vesting is an investment term that means an owner of shares in a company gains entitlement to shares of company stock. When an employee receives equity as part of their compensation, they are vested over time. The idea behind vesting is that the person has to stay with the company for a certain duration before they can receive any benefits from the equity. Some companies may also have vesting schedules that determine how employees receive their vested benefits after termination of employment.
Performance-based restrictions require an employee to meet a certain level or target before they can exercise their right to buy shares at a fixed price.
After the stock is vested, the person can exercise it. However, this is never mandatory. Depending on one’s choice, they can either sell a portion of your shares or pay in cash to cover the costs of exercising. This is known as a cashless exercise of options.
After leaving a company, a person typically has a certain amount of time to exercise any vested NSOs. This period is called the “post-termination exercise period” or PTE. In case they do not exercise their options before their expiration date, they will lose the chance to buy them. In the following section, we will compare nonqualified stock options and incentive stock options.
Nonqualified Stock Options vs. Incentive Stock Options: What’s the Difference?
Nonqualified Stock Options (NSOs) and Incentive Stock Options (ISOs) are the two types of stock options for equity compensation. Incentive stock options are more commonly referred to as Qualified Stock Options. Because NSOs do not have to meet all requirements of the Internal Revenue Code, they are more widely used than incentive stock options.
The following are the two major differences between NSOs and ISOs:
- Nonqualified stock options are taxed the same way as ordinary income i.e paying taxes on the spread between the grant price and exercise price at the standard income tax rate. Grants of non-qualified stock options do not have any tax advantages. However, incentive stock options are subject to be taxed at the capital gains rate if they meet certain qualifications.
- Nonqualified stock options are granted to employees, partners, consultants, and other workers who are not on the company's payroll. In contrast, incentive stock options are reserved only for employees, offering them a discounted price for buying the stock.
How do Non-Qualified Stock Options Work?
A nonqualified stock option is granted through a legal agreement between an employer and employee detailing the conditions under which the company is willing to sell you stock.
Many companies provide their employees with stock options as a form of compensation as well as to motivate them to do better. In most cases, stock options are offered to new employees when they join the company.
Nonqualified stock options are basically a way for employees to buy the stocks at a certain price. If the stocks rise, then they can sell them at higher prices and make huge profits. The stock is granted with the expectation that its value will increase so the employees can benefit from its gains.
For example, if a company's stock is valued at $100 per share at the time of the nonqualified stock option grant, the exercise price will be $100. It gives the person an opportunity to purchase stock at $100 per share in the future, even if the stock is valued higher at that time.
How are non-qualified stock options taxed?
Non-qualified stock options are subject to taxation when they vest in a taxable account. As the value of options would have increased over time, an employee would have made a profit when exercising their nonqualified stock.
Upon exercising your nonqualified stock options, the difference between the current market price and the exercise price, is your profit.
Here is a simple formula to calculate your tax liability
Tax Liability = Number of Exercised Shares * (Market Value of Shares at Exercise – Strike Price)
For example, if you exercise 100 vested options at a grant price of $10 and the current market price of the stock is $20, you would be liable to pay income tax on the $1000 gain.
Moreover, you are also liable to pay tax when you sell your stock. When you exercise your stocks, you have two options: you can either hold on to them or you can sell them off immediately.
Selling right away will not result in any capital gains, so you won't have to pay any additional taxes.
On the other hand, if you hold your stock for less than a year, you'll need to pay short-term capital gains tax on the increase in value since the exercise date. If you intend to hold your stock for at least a year before selling, then it would be categorized as a long-term capital gains tax
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