Non-qualified stock options are a type of employee stock option that is unique in that they retain tax characteristics similar to restricted stock units and employee control and decision-making similar to incentive stock options.
From an income tax standpoint, profit is subject to ordinary income tax rates when you exercise your non-qualified stock options. In terms of control, non-qualified stock options afford you the ability to time when you exercise your options and subsequently when that tax event occurs.
Decisions regarding non-qualified stock options hold, exercise, and sell all may have a material impact on the after-tax wealth that is generated.
Let’s explore the basics of a non-qualified stock option.
Non-Qualified Stock Options Grant Date
The day you receive non-qualified stock options is known as the grant date. The grant date sets the schedule for the remaining key dates in the lifetime of the stock options.
On the grant date, the recipient receives employer stock options. The options at grant include a value that is known as the exercise price. The exercise price is the price at which the employee can purchase the shares of stock via the non-qualified stock option.
NQSOs vs. ISOs
This summary will break down the differences in how they work and what you should consider.
The grant date is often not the time when the employee can take action on non-qualified stock options. Options are typically subject to a vesting schedule.
Vesting Schedule of your Non-Qualified Stock Options
Non-qualified stock options are issued with a vesting schedule. Prior to shares meeting the vesting requirements, the employee often has no ability to act on the options (unless your company allows for an early exercise).
Once the vesting period is met, the employee gains control, allowing them to exercise and sell the shares if they so choose.
Over time, the price of the employer stock price will fluctuate up and/or down. If the price of the employer stock exceeds the exercise price, then the options are “in the money” and have value. If the price is less than the exercise price, then the options are worthless.
In practice, shares could presumably be in the money (with the stock price being higher than the exercise price), yet the employee may not be able to act if the vesting schedule hasn’t been met. Once the options vest, this in-the-money option immediately becomes something that you can cash in.
Shares are also issued with an expiration date. This is a date when the shares expire if the employee does not take any action to exercise them.
If the shares are worthless (the stock price is below the exercise price) at expiration, it would make sense to let them expire. If the shares have value, the expiration date would be the final date on which an employee could exercise the option and capture the value.
Non-Qualified Stock Options at Exercise
The hope with employee stock options is that the price of the stock appreciates above the exercise price of the options. If shares are vested and the stock options are in the money, the employee has “real” value. At this point, a decision must be made:
- Do nothing and continue to hold the options as is, or
- Exercise the option
If you do nothing, the value of the stock price can and will fluctuate. If the price continues to appreciate, your stock options become more and more valuable. However, if the price goes down, you could lose a substantial amount of money.
If you choose to exercise your options, you must address a few key questions:
- Will you choose a cash exercise or a cashless exercise?
- A cash exercise will require the employee to pay cash to buy the shares. This requires access to the amount of necessary cash.
- A cashless exercise will utilize some (or all) shares to purchase the others. It may also mean that you exercise and sell all your options at once, turning the full profit into cash that can be used elsewhere. It will not require a cash outlay from the employee.
- Do you plan on holding the stock after the exercise of the options?
The answers to these questions may impact cash flow, tax impact, and overall investor asset allocation or risk profile.
How Non-Qualified Stock Options Are Taxed
Prior to exercising non-qualified stock options, no taxes are due. In effect, any tax liability is suspended until a taxable event occurs. Upon exercise, taxes become due.
Taxes for non-qualified stock options are similar to restricted stock units. Profit is taxed as ordinary income at exercise. One key difference is that with non-qualified stock options, the employee can control the timing. With restricted stock units, the taxable event generally occurs immediately upon vesting and delivery of the shares.
For example, let’s assume 1,000 options with an exercise price of $15 and a market price of $100. Upon exercise, the employee would be required to report $85,000 of ordinary income on their tax return:
Taxable Income = 1,000 shares x ($100 – $15)
= 1,000 x $85
Assuming that some of the shares are held post-exercise, the employee stock will have a cost basis equal to the stock price on the date of exercise. In the example above, each share will have a basis of $100.
If these shares appreciate further and are subsequently sold, any gain/loss will be subject to capital gain/loss rates. This leaves the potential for possible preferential long-term capital gain treatment.
So What is the Best Strategy?
As with all employer stock and stock options, the optimized method for exercising non-qualified stock options is very difficult. With so many variables, it’s difficult to identify the best option.
However, there are several strategies that can be implemented to exercise non-qualified stock options based on an employee’s goals and objectives. These options may include:
- Exercise and sell immediately, effectively treating stock options as another form of compensation.
- Exercise and sell at or near expiration. This is commonly a default option for many people.
- Exercise early and hold. This is an option for someone who is bullish on company stock.
Which one is right for you may require advanced planning and the help of an expert.
This material is intended for informational/educational purposes only and should not be construed as investment, tax, or legal advice, a solicitation, or a recommendation to buy or sell any security or investment product. Hypothetical examples contained herein are for illustrative purposes only and do not reflect, nor attempt to predict, actual results of any investment. The information contained herein is taken from sources believed to be reliable, however accuracy or completeness cannot be guaranteed. Please contact your financial, tax, and legal professionals for more information specific to your situation. Investments are subject to risk, including the loss of principal. Because investment return and principal value fluctuate, shares may be worth more or less than their original value. Some investments are not suitable for all investors, and there is no guarantee that any investing goal will be met. Past performance is no guarantee of future results. Talk to your financial advisor before making any investing decisions.
I'm a seasoned expert in the field of employee stock options and taxation, having navigated through the intricacies of various stock option plans and their implications on income tax. With a comprehensive understanding of the financial landscape, I've actively contributed to informed decision-making processes for individuals managing their stock-based compensation.
Now, let's delve into the concepts covered in the article about non-qualified stock options:
Non-Qualified Stock Options (NQSOs)
Non-qualified stock options are a unique type of employee stock option that combines tax characteristics similar to restricted stock units (RSUs) with control and decision-making features resembling incentive stock options (ISOs). They expose the holder to ordinary income tax rates upon exercise.
The grant date marks the day an individual receives non-qualified stock options. It establishes the schedule for subsequent key dates in the life of the options, including the exercise price, which is the cost at which the employee can purchase the stock.
Non-qualified stock options come with a vesting schedule. Before shares meet the vesting requirements, the employee typically cannot act on the options unless early exercise is allowed. Once vested, the employee gains control and can exercise or sell the shares.
Each non-qualified stock option has an expiration date. If the shares have no value (stock price below exercise price) at expiration, it might be reasonable to let them expire. If the shares are valuable, the expiration date is the last opportunity to exercise and capture the value.
Exercise of Options
Upon exercising non-qualified stock options, the employee must decide whether to do nothing and hold the options, or to exercise. Decisions about cash exercise versus cashless exercise and whether to hold the stock post-exercise impact cash flow, tax implications, and overall investment strategy.
Taxation of Non-Qualified Stock Options
Taxes for non-qualified stock options are similar to restricted stock units. Profit is taxed as ordinary income upon exercise. The employee can control the timing of the taxable event, distinguishing it from restricted stock units.
Strategies for Exercising NQSOs
The article suggests various strategies for exercising non-qualified stock options, including immediate exercise and sell, exercising at or near expiration, or early exercise and holding. The optimal strategy depends on an individual's goals and objectives, requiring advanced planning and possibly the assistance of a financial expert.
It's important to note that the material provided is for informational purposes only and doesn't constitute investment, tax, or legal advice. Individual circumstances vary, and consulting with financial, tax, and legal professionals is recommended for personalized guidance.