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NSO Stock Options: Tax and Exercise

NSO stock options refer to a type of stock option that does not qualify for favorable tax for the employee. In other words, it is a type of option wherein one pays ordinary income tax on the difference between the grant price and the price at which the option is exercised. That is, you pay taxes both the time you exercise the option (purchase shares) and when you sell those shares. We will cover non-qualified stock options tax treatment and how to exercise them.

How do non-qualified stock options work?

Non-qualified stock options work by a company giving employees as well as other stakeholders options to buy shares as part of a compensation package. There is a specific exercise price for the shares.

Typically, companies have a vesting period where the recipients of NSO stock options earn the right to exercise a higher percentage of their NSO stock options the longer they remain with the company. For example, after two years, an employee may vest 50% of their nonqualified stock options which means that they can only cash in on their options unless they stay longer.

After vesting, the recipients of NSO stock options can decide when to exercise on the basis of whether the company’s stock price rises above the exercise price. It is from there that the options become regular shares that shareholders can do as they please.

It is important for employees to keep in mind that any expiration date that the company sets because these options would become worthless if it is not cashed in before the expiration date. These types of stock options are fairly common because they have fewer restrictions than another type of stock option known as an incentive stock option (ISO).

Non qualified stock options give employees the right to buy a set number of shares of their company at a preset price within a designated time frame. As earlier stated, it may be offered as an alternative form of compensation to workers and also as a means of encouraging their loyalty to the company. This means that the company connects part of the employees’ compensation to its growth.

NSO stock options usually reduce the cash compensation that employees earn from employment. The price of these stock options is typically the same as the market value of the shares when the company avails of such options, also known as the grant date. There will be a deadline for employees to exercise these options, known as the expiration date. The employee will lose the options if the date passes without them being exercised.

Also, the terms of the option could require the employees to wait a period of time for the options to vest. Furthermore, they may lose the options if they leave the company before the stock options are vested. There may also be clawback provisions that allow the company to reclaim NSO stock options for various reasons. This includes the insolvency of the company or a buyout.

There is an expectation that the price of the company’s shares will increase over time. This means that employees stand potentially to acquire stock at a discount grant price (also known as the exercise price) that is lower than later market prices. However, the employee will pay income tax against the difference from the stock’s market share price when the option is exercised. Once the options are exercised, the employee can decide to either sell the shares immediately or retain them.

NSO stock options
NSO stock options

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Non qualified stock options tax

With these stock options, one pays tax both when the options are exercised and when the options are sold.

Non-qualified stock options have some unique tax characteristics. Generally, one has to pay ordinary income taxes on the difference between the cost to exercise the options and the value of the options at the time they were exercised even if the shares are not sold right away.

The company will usually withhold ordinary income tax which includes both payroll taxes and regular income taxes on the spread when exercised. The spread is the difference between the strike price which is the fixed purchase price and the current market price of those stock options.

For example, if you exercise 200 vested options at a grant price of $1 and the current price then becomes $2, you will have to pay ordinary income tax on the $200 gain.

Related: Advisory Shares Meaning and Example

When to sell nonqualified stock options

After exercising your options, you can either sell your stock right away or hold it. If they are sold right away, there will be no capital gain and you will only need to pay income tax on the spread.

If you sell your stocks within a year of when the options were exercised, you will pay short-term capital gain tax on any increase in value since the exercise date. If you hold unto your stocks for more than one year and sell thereafter, you will pay long-term capital gains tax. This is typically a lower rate than the tax rate of short-term capital gains.

When can I exercise non-qualified stock options?

Typically, you gain the ability to exercise your NSO stock options on a set schedule as you remain with a company over time. This refers to vesting. Here, you can exercise your nonqualified stock options as soon as they vest. You can also choose not to exercise as well.

If you choose to exercise, you can either pay the strike price in cash or sell a portion of your shares in order to cover the cost of exercise which is known as a cashless exercise. In this case, you can find out if your company allows cashless exercises.

If you leave your company, you will always have a certain amount of time, that is the post-termination exercise period (PTE), to exercise your vested nonqualified stock options. If you fail to exercise your options before the end of this period, you will lose your opportunity to purchase them.

In order to maximize your potential profit, it is important to talk to a tax advisor before exercising and selling your non-qualified stock options. Although advisors cannot predict the future stock performance of your company, they can help you to understand your next steps as well as minimize your tax liability.

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Qualified vs non qualified stock options

One area in which qualified and nonqualified stock options differ is that qualified stock options can only be issued to employees while NSO stock options can be issued to anyone such as vendors, employees, and the board of directors.

The exercise price of qualified stock options must be at least equal to the fair market value at the time of grant and for 10%+ shareholders, the exercise price must be equal to 110% or more of the fair market value at the time of grant. On the other hand, nonqualified stock options may have any exercise price.

For qualified stock options, there is no tax at the time of grant or at exercise. There is a capital gain or loss tax upon the sale of stock if the employee holds stock for at least a year after exercising the option. For NSOs, there is also no tax at the time of grant, however, the recipient receives ordinary income or loss upon exercise which is equal to the difference between the grant price and the fair market value of the stock at the date of exercise.

For qualified stock options, there are no deductions available for the company. For non-qualified stock options, on the other hand, the company can deduct the costs incurred as operating expenses as long as it fulfills withholding obligations. This cost is equal to the ordinary income that the recipient declares.

The aggregate FMV for qualified stock options which are determined as the grant date that are exercisable for the first time should not exceed $100,000 in a year. For NSO stock options, on the other hand, there is no limit placed on the value of stocks that can be received as a result of exercise.

For qualified stock options, there are restrictions to the holding period while for nonqualified stock options, there are no restrictions.

Qualified stock options must be nontransferable and exercisable not more than 10 years from the grant. NSO stock options on the other hand may or may not be transferable.

Non qualified stock options vs ISO

Generally, nonqualified stock options are easier for employers to provide because they are less restrictive than incentive stock options such as who can receive them and the value that can be exercised. In essence, only employees can receive ISOs.

ISOs, however, can be more tax-friendly as all earnings could potentially count as long-term capital gains. This depends on holding periods. With NSOs, the difference between the exercise price and the fair market value at the time the stock option is exercised can be taxed as ordinary income. In other words, NSO stock options do not receive special tax treatment while ISOs qualify for special tax treatment. However, shareholders must hold shares for one year from the date of exercise and two years from the date of grant.

While NSO stock options are taxed at the time they are exercised, ISOs are taxed at the time they are sold.