Stock options are becoming a popular method of employee compensation. This is especially seen in startups, where cash needs to be conserved, equity compensation in the form of stock acts as a competitive recruitment tool. In this article, we take a closer look at one category of equity compensation, the non-qualified stock option. We will explore the basic concepts associated with this category of stock option and compare it with other popular ones, especially in terms of taxation. Let’s begin.
Non Qualified Stock Option
Non qualified stock options are the most preferred equity compensation method used by employers. But to understand how this works in favor of the company, one must understand the basics of equity compensation for employees. We begin with the term ‘stock option’.
What is a stock option?
When an employee is granted stock options, it translates as the right to buy company shares at a fixed price on the grant date. This is a special privilege granted to employees of a company in comparison to external shareholders, who if interested, have to buy company shares at the going market price. Stock options provide the employees with an opportunity to become shareholders in their company of employment.
There are three forms of equity compensation: Incentive stock options (ISO), Non qualified stock options (NSO), and Restricted stock units (RSU). Each one varies in terms of their exercising options and taxation policies. But the basic idea is, using these instruments employers engage new talent in the business with the accountability of delivering their best. Only if the business grows and makes a profit, the value of equity will grow and in turn, employees benefit from their stock options.
What is a non qualified stock option?
Non qualified stock option (NSO) is one where employees are taxed both while purchasing the stock (exercising options) as well as while selling the stock. Using this option, employers benefit from tax deductions, but employees end up paying higher taxes. These are called ‘non-qualified’, as unlike ISOs, NSOs do not meet all the requirements of the Internal Revenue Code. Before delving deeper into this, let’s familiarize a few basic concepts that govern the terms of these stock options:
- Grant Date: The date on which an employee receives the non qualified stock option. However, receiving the stock does not mean owing it with immediate effect. On the grant date, the employee is being granted only the right to buy a certain amount of shares at a fixed price on a later date. But the grant date is important as it sets the timeline for the whole equity compensation package.
- Strike price: The price at which stock options are given to an employee on the grant date is the strike price. This is a fixed price offered only to the employee and does not vary with market fluctuations. The idea is that share prices will increase as the business grows. So at a later stage when employees exercise their options at the strike price (which will be lower than the market price on that date), they profit from the difference in prices.
- Vesting schedule: Employers grant stock options based on vesting schedules. A ‘vesting period’ is the time an employee has to wait (in service of the company) before they receive the right to purchase all the granted stock. It can range from 12 months to 5 years.
- Expiration date: After the vesting period, once employees have received complete rights to exercise all of their non qualified stock options, they have to use it within a set time frame. This is the expiration date. Beyond this date, employees lose their claim over these stocks.
NSO vs ISO
Though both are methods of equity compensation, it is interesting to observe the differences between NSO vs ISO. The following table consolidates some of the basic features in which these two stock options vary from one another:
|Granted only to employees||Granted to all stakeholders: employees, directors, consultants, advisors, and others.|
|Limited to $100K per year||No limits|
|During the grant, the strike price must be at least similar to the current fair market value of stocks||During the grant, if the strike price is lesser than the current fair market value, the price difference is considered deferred compensation. Might incur an additional 20% federal income tax|
|Taxed only at a sale. Not while exercising||Taxed both at exercise and sale|
|If an employee waits for at least 2 years from the grant date, holds on to the stock for at least 1 year after exercising options, and continues employment in the company for at least 3 months before the sale date, if all these 3 criteria are met, they become eligible for the special long-term capital gain tax rate. If not, an ordinary income tax of 30% is levied.||After exercising stock options, if the stocks are held for less than 12 months – short term capital gain rates are levied (similar to ordinary income tax). If stocks are held for more than a year, long term capital gain rates are levied in the range of 0 to 20%
How Non Qualified Stock Options are Taxed?
As discussed earlier, employees holding non qualified stock options face double taxation; First while purchasing the stocks at the strike price and then while selling the stocks at market rate.
Once the taxable amount is determined, here is how the taxation part works:
At Purchase – Let’s say an employee is holding 150 shares at a strike rate of $10 per share. While purchasing or exercising, let’s say the share price has reached $20 per share. The employee will be taxed on the additional profit of $1,500.
At sale – The sale stage offers three options to employees:
- If stocks sold immediately – Post exercise, if the employee decides to sell all stocks immediately, there are no capital gains. In this case, no additional tax is levied while selling.
- If stock is held for less than 12 months – Post exercise, if employees decide to sell their non qualified stock options within one year of purchase, short-term capital gains tax is levied. This is similar to the ordinary income tax and is close to 30% of the taxable income.
- If stock is held for more than 12 months – Post exercise, if employees hold on to the stock for more than a year since the date of purchase, they are offered a special taxation structure under long-term capital gains tax. This is much less than the ordinary income tax and usually in the range of 0 – 20% of the taxable income.
How Non Qualified Stock Option Works?
When an employee actually becomes eligible to exercise their options will depend on the non qualified stock options vesting. Vesting ensures that employees stay committed to the growth of the company. If the business posts a positive growth, so does the price of stocks. On vesting, an employee has to choose from one of these 3 options:
- Exercise the NSOs and sell immediately
- Exercise the NSOs and sell at or closer to the expiration date
- Exercise the NSOs early and hold on to it if the employee intends to go bullish on the company stock
Either way, taxes will be levied both at purchase and sale of non qualified stock options. An employee can choose to use cash or go cashless while exercising these stock options and paying for taxes.
Let’s try to understand this with an example:
Emily joins a Company ABC as a design specialist in June 2020. As part of her compensation package, she is granted 500 non qualified stock options at a strike price of $10. The company stock is now worth 500*$10 = $5,000. Here the vesting schedule spans 5 years. By June 2025 let’s say the company stock price has hit $50 per share. Now on full vesting, Emily can exercise and sell her stock for 500 * $50 = $25,000. Since her shares were already worth $5,000 on the grant date, Emily’s profit would be $20,000 (500 stock options X ($50-$10)).
If Emily chooses to sell all stock immediately, the ordinary income tax of 30% will be levied on the gains, ie. 30% of $20,000 = $6,000. Thus the net result of the sale would be $14,000 for Emily.
If she chooses to hold onto the stock until the end of the year, and the stock price rises to $60, then she would gain an additional $5,000 (500 shares * $10 additional gain), and need to pay 30% on this gain, ie. 30% of $5,000= $1,500. Thus the net result of the sale at the end of 2025 would be $17,500.
In the end if Emily chooses to hold onto the stock for another year, (let’s say until the end of 2026) and the stock rises to $70, then she would be taxed at the long term capital gains rate on any difference after the exercise date. So the total additional gain would be $10,000 (500 shares & $20 additional gain), and the need to pay $15% (assumed long term capital gains tax rate) on this gain, ie. 15% of $10,000 = $1,500. Thus the net result of the sale at the end of 2026 would be $22,500.
And this is how the total numbers would look in a table:
|Year||Gross Gain||Tax||Total Gain|
Issue and Manage Employee Stock Options on Eqvista
An employee stock option is a powerful tool for startups. It provides the much-required incentive and remuneration for fresh talent joining the company. Since a startup environment is highly dynamic and demanding, holding stock options in the company they are building, makes the employees feel directly involved in the business.
Thus to keep all records clean and updated, it is best to use sophisticated software such as Eqvista that easily helps issue, track, and manage employee stock options. As the company grows and expands, Eqvista is capable of handling stock options of the top management and multiple investor rounds as well. Here are our other offerings related to company equity management. To discuss further, reach us today.