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.

That said, there are some scenarios where the taxing and measuring of this income based on the date the company provided the NSO. The date one decides to report the income is dependent on if the non qualified stock option has a market value that is readily determinable.

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.

When the recipient of a grant sells the shares they obtained through NSOs, they are taxed on its appreciation at long or short term capital gains, based on the amount of time they kept the stock.

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.

NSO Taxation

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.

Employees who depart their organization usually have a certain period for exercising their vested non qualified stock options. This period, also known as post termination exercise (PTE), is worth remembering as once it expires, your NSO is worthless. You will lose your chance to buy your options once the PTE is over, so make sure you utilize your options wisely.

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:

TimeNumber of OptionsTotal Options
March 31st, 2016100100
June 30th, 2016100200
September 30th, 2016100300
December 31st, 2016100400
March 31st, 2017100500
June 30th, 2017100600
September 30th, 2017100700
December 31st, 2017100800
March 31st, 2018100900
June 30th, 20181001,000
September 30th, 20181001,100
December 31st, 20181001,200

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 Options1,200
Exercise Price$5
Fair Market Price$8
Fair Market Value of Shares$9,600
Amount to pay the company($6,000)
Total Gain$3,600

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 Shares1,200
Fair Market Price$12
Fair Market Value of Shares$14,400
Original “cost” of shares($9,600)
Total Gain$4,800

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.

Non Qualified Stock Option

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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