A non-qualified stock option (NSO) is a type of employee stock option where you pay ordinary income tax on the difference between the grant price and the price at which you exercise the option.
NSOs are simpler and more common than incentive stock options (ISOs). They are called non-qualified stock options because they do not meet all the requirements of the Internal Revenue Code to be qualified as ISOs.
Key Takeaways
- Non-qualified stock options require payment of income tax on the difference between the grant price and the price of the exercised option.
- NSOs might be provided as an alternative form of compensation, especially in early-stage companies.
- NSOs allow employees to assume some risks of a new business but also potentially earn higher rewards if the company succeeds.
- NSOs allow the holder to buy a company’s stock at a preset price in the future. If the holder does not exercise them before the expiration date, they lose the option.
How Non-Qualified Stock Options (NSOs) Are Used
NSOs give employees the right, within a designated timeframe, to buy a set number of shares of their company’s stock at a preset price. They might be offered as an alternative form of compensation to encourage loyalty with the company.
Important: Non-qualified stock options often reduce the cash compensation employees earn from employment.
The price of these stock options is typically the same as the market value of the shares when the company makes the options available, known as the grant date. Employees will have a deadline to exercise these options, known as the expiration date. If the options are not exercised by this date, the employee loses the options.
There is an expectation that the company’s share price will increase over time. This means employees may acquire stock at a discount if the grant price—also known as the exercise price—is lower than the market prices later on. However, the employee will pay income tax on the difference between the grant price and the market price at the time of exercising the options. Once exercised, the employee can choose to sell the shares immediately or retain them.
As with other types of stock options, NSOs can help companies reduce direct cash compensation while tying part of an employee’s compensation to the company’s growth.
The terms of the options may also include a vesting period before the employee can exercise the options. Employees could lose the options if they leave the company before they vest. Clawback provisions might allow the company to reclaim NSOs under certain conditions, such as insolvency or a buyout.
For smaller and younger businesses with limited resources, such options can substitute for salary increases and function as a recruiting tool, compensating for lower salary offers when hiring talent.
When Should You Exercise Non-Qualified Stock Options?
The optimal time to exercise NSOs is when the stock value is higher than the cost of exercising the option but before the option expires. This ensures the stock is more valuable than the cost of buying it.
How Are Non-Qualified Stock Options Taxed?
When you exercise NSOs, you must pay taxes on the difference between the market price and the exercise price. This is called the compensation element and will be reported on your W-2 as income. When you finally sell the stock, you must also report the capital gain (or loss) between the original market price and the sales price on Schedule D of your tax return. A short-term capital gain applies if sold within a year and is taxed at ordinary income levels. Selling after a year or longer classifies it as long-term capital gains, taxed at a lower rate.
Should You Accept Non-Qualified Stock Options As Compensation?
While stock options carry more risk than direct salary, they can be more lucrative if the company has a chance for strong growth. Employees should evaluate their company’s potential growth and the proportion of shares offered. If offered a small percentage of the company’s equity or if the company has low growth potential, negotiating for a higher salary might be a better option.
The Bottom Line
Non-qualified stock options serve as an alternative form of compensation that provides employees the opportunity to gain equity in their employer’s company. This allows employees to buy shares at a discounted price, assuming these shares will appreciate with the company’s success. However, this comes with inherent risk, and employees should carefully consider their company’s future potential when evaluating these options.
Related Terms: incentive stock options, employee stock purchase plan, capital gains tax, vesting period.
References
- Internal Revenue Service. “Publication 525, Taxable and Nontaxable Income”, Page 12.
- Internal Revenue Service. “Publication 525, Taxable and Nontaxable Income”, Page 11.
- Internal Revenue Service. “Publication 525, Taxable and Nontaxable Income”, Pages 11-12.
- Internal Revenue Service. “Topic No. 409, Capital Gains and Losses”.
