NSO or Non Qualified Stock Option Taxation
Under traditional NSO plans, the income is taxed and measured on the exact date the employee decides to exercise their non qualified stock option.
Organizations provide their workers with NSOs, also known as non qualified stock options, as a compensation for their skills. Unlike other types of employee stock options, companies can also offer NSOs to independent contractors. A non qualified stock option allows employees to buy shares of the company’s stock for a predetermined rate.
The overall value of the NSO, minus the amount paid for exercising the option, is essentially the extra compensation for an independent contractor or employees. Under traditional NSO plans, the income is taxed and measured on the exact date the employee decides to exercise their non qualified stock option.
Non Qualified Stock Option
There are a lot of minor details that make non qualified stock options vastly different from other forms of employee stock options. And these details can really affect how your NSOs are taxed and how much you need to pay to the IRS. Let us take a closer look at what NSOs really are, what they offer to the employees who receive them, and how non qualified stock options are taxed.
What is a Non Qualified Stock Option or NSO?
Non-qualified stock options offer workers, whether independent contractors or regular employees, the right to obtain a certain amount of the company shares for a set price. Employers tend to offer NSOs as an alternative type of compensation, to make sure they remain loyal and work for the company’s best interests. NSOs are great for companies, especially newer ones, as they minimize cash compensation an employee would earn during their employment.
The rates for said stock options are usually the same as their market value when the organization makes options like these available (aka, the grant date). Employees have to exercise their options within a particular guideline called, “the expiration date”. Not doing so could result in unfavorable circumstances, reducing their option’s overall worth or even rendering them worthless.
With non qualified stock options, there is always an expectation that the organization’s share price will eventually increase. This means that workers can potentially gain stock for discounts, in case the exercise or grant price is lesser than the later market rates. After exercising the options, the employee can retain or sell their shares immediately, a feature that makes non qualified stock options quite beneficial for most workers.
It is also worth noting that an employee can lose their options if they depart the company prior to their stock option’s vesting. In addition, the presence of claw back provisions could let the company reclaim the non qualified stock options for various reasons, one of which could be the company’s insolvency or buyout.
As mentioned earlier, smaller businesses that don’t have an excessive amount of resources often offer NSOs instead of big salary increases. Some of them also use NSOs for recruiting purposes, especially when it comes to hiring highly skilled talent and retaining them for long periods.
How NSO Benefits Employers
Non-qualified stock options are advantageous for employers just like other types of stock options are beneficial for them. First off, NSOs serve as a handy compensation method to reduce excessive cash flow, letting companies retain more liquidity and cash for fulfilling other needs.
The best benefit of non qualified options, however, is that they let companies benefit from tax deductions, matching the income amount from stock options gained by the employee (receiver). This goes to show that NSOs are mutually beneficial for the employers and employees, increasing their financial stability for the long run.
Non Qualified Stock Options vs Incentive Stock Option
When companies give options, it could either be an incentive stock option (ISO) or a non qualified stock option (NSO). Both of them give the recipients the right to buy stocks for predetermined rates in the future, but they have varying restrictions and tax consequences for the grant provider and the recipient.
Organizations can only offer ISOs to employees. An ISO grant should not exceed the amount of one $100K per year, based on the strike price. If an option goes above this limit, it will automatically become an NSO. An ISOs strike price should be at least close to the stock’s present fair market value. What’s more, the options are not transferable unless the recipient passes away.
Generally, if an ISO recipient decides to part ways with the company, they should exercise the options inside 3 months (could be 12 months if the recipient leaves due to disability). It is also worth keeping in mind that incentive stock options take 10 years to expire after their date the company granted them.
In contrast, non qualified options are very different, especially when it comes to the limitations. As mentioned before, companies can offer NSOs to regular employees, individual contractors, external consultants, directors, vendors, and others. That said, a non-qualified option’s strike price is less than the stock’s fair market value when the company grants it. With NSOs, the price difference becomes the deferred compensation. In some cases, it could be subject to an extra 20% penalties and federal income tax.
How Non Qualified Stock Options Work
Companies, especially smaller startups, give NSOs expecting that underlying prices for the stock will improve in the future. Employers prefer non qualified stock options because they act as an alternative means of compensation while incentivizing workers, making them work harder. This benefits both the employee and the employer as it increases stock prices.
Understanding the ins and outs of non qualified stock options tax is important to ensure you exercise them the right way. How you exercise your non qualified stock options will greatly affect how much tax you pay in the end. Below, we will discuss the best time to exercise non qualified stock options and how their taxation works.
When Can I Exercise NSO?
In most cases, you cannot purchase your entire shares immediately and work for the company to become eligible for buying your shares. The term used to describe this is “vesting”. For those who don’t know, you have the freedom to exercise stocks as soon as they vest. However, there is no rule against not exercising the stock. If you do decide you exercise, selling a part of your shares or making a cash payment for covering the exercise cost would be a wise choice. However, ensure that your employer permits cashless exercises.
How are NSOs Taxed?
When someone exercises their non qualified stock option, the difference between the stock’s market price and the exercise or grant price is considered as ordinary income earned, despite the recipient holding the stock and exercising the options. What’s more, the earned income is predisposed to payroll taxes such as Medicare and social security, along with regular income tax at the applicable tax rate.
It is worth remembering that there isn’t any tax consequences associated with NSOs when you receive them for the first time. However, you will have to face tax consequences if you exercise the NSO. Although there isn’t any direct AMT (alternative minimum tax) consequence associated with exercising a non qualified stock option, you may be subject to it if your income is on the higher side. Upon buying shares or exercising your option, the share’s cost basis is essentially the exercise date’s stock price.
Once you sell the shares later on, the NSO taxation will follow the traditional rules for gains and losses on any investment. If someone decides to hold shares for a year or higher, any type of gain will be taxed at complimentary long term capital gains prices. However, holding the shares for any time less than a year, the gains will be taxed at the holder’s ordinary income tax rates (they are often on the higher side).
Let’s take an example to see how non qualified stock options tax works.
Let’s say an employee, Greg, has received 1,200 NSO options from his company on January 1st, 2016, that vest quarterly over a 3 year period, with an exercise price of $5.
The vesting schedule for Greg would look like this:
|Time||Number of Options||Total Options|
|March 31st, 2016||100||100|
|June 30th, 2016||100||200|
|September 30th, 2016||100||300|
|December 31st, 2016||100||400|
|March 31st, 2017||100||500|
|June 30th, 2017||100||600|
|September 30th, 2017||100||700|
|December 31st, 2017||100||800|
|March 31st, 2018||100||900|
|June 30th, 2018||100||1,000
|September 30th, 2018||100||1,100|
|December 31st, 2018||100||1,200|
Once all of Greg’s 1,200 options have vested, he can exercise them as he wants. Let’s say the company’s fair market stock price was $8 in January 2019, and Greg decided to exercise his nonqualified stock options. The total gain would look like:
|Number of Options||1,200|
|Fair Market Price||$8|
|Fair Market Value of Shares||$9,600|
|Amount to pay the company||($6,000)|
After exercising the share and paying $6,000 back to the company, Greg would have a total value of $9,600 in shares, and have a total gain of $3,600. He would need to pay income tax on this $3,600 gain. Now Greg has two options, either sell the shares and get $9,600 now (and pay short term capital gains) or wait until next year in hopes the stock price increases, and pay long term capital gains tax.
Let’s say Greg waits until June 2020 when the company’s stock price rises to $12 a share. Greg would then sell his shares back to the company and realize a nice gain. It would look like this:
|Number of Shares||1,200|
|Fair Market Price||$12|
|Fair Market Value of Shares||$14,400|
|Original “cost” of shares||($9,600)|
As Greg already paid income tax on his shares in 2019 up to their market value, $9,600, he would only need to pay tax on the capital gains from that point, ie. $4,800. Assuming a tax rate of 15%, Greg would only need to pay an additional $720 in tax for his NSOs.
Interested to issue NSOs in your Company?
Needless to say, if you possess non qualified stock options, make sure that you understand their fundamental features like vesting, schedule, exercise price, availability of early exercise chances, end date, grace periods for termination. It would also help if you took a close look at the tax consequences that result from selling shares and exercising options to improve your tax planning strategies.
Eqvista is a sophisticated equity management software that helps companies handle their share and option grants. You can easily issue NSOs, track its vesting, exercise the shares, and even repurchase options or shares all through the platform. This can help you easily track the amount of tax to pay for your NSOs. Here are some other important features of Eqvista. To know more about the Eqvista contact us today!
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