- Non-qualified stock options (NSOs) provide employees and other stakeholders with the right (but not the obligation) to purchase shares of company stock at a predetermined price.
- NSOs can be profitable if a company’s stock price rises more than the exercise price.
- NSOs may not be as tax-friendly as other types of stock options, such as incentive stock options (ISOs).
How Do Non-Qualified Stock Options Work?
A non-qualified stock option (NSO) is a form of equity compensation that can be provided to employees and other stakeholders. An NSO gives you the choice to purchase shares of your company’s stock at a predetermined price, which can be profitable if the stock price rises above that level. The price is known as the exercise price or strike price.
Ideally, the market will rise above the exercise price by the time you exercise the options (purchases the shares). That way, you can sell the stock for more than you purchased the options for and earn a profit.
Examples of NSOs
For example, you as an employee might receive stock options that have an exercise price of $10 per share. If you had the option to purchase 100 shares, you could pay $1,000 to exercise those options at $10 per share.
If the stock price rose to $20 per share, you could exercise the options for $1,000, then sell the 100 shares for $20 per share, or $2,000. You’d make $1,000 in profit.
You could also hold the shares and hope that the stock price rises even more, which would make the stock options more profitable.
Paying Taxes on Non-Qualified Stock Options
NSOs do have some unique tax characteristics. Generally, you have to pay ordinary income taxes on the difference between the cost to exercise the options and the value of the options at the time you exercise them, even if you don’t sell the shares right away. So, as in the example above, it would be as if you earned an extra $1,000 in income and have to pay income taxes on that.
Then, you would pay capital gains taxes if you held onto the shares after exercising and ended up selling for additional gain. For example, after exercising at $20 per share, suppose the stock rose to $30 per share. If you sold your 100 shares at that price, you would pay capital gains taxes on the additional $1,000 in earnings.
Capital gains taxes are dependent on how long you hold the shares.
Long-term capital gains tax rates are 0%, 15%, or 20%, and that rate is dependent on your income and if you held the asset for more than one year. Short-term capital gains are when you hold an asset for less than one year. The rate is the same as your ordinary income tax rate.
Other Considerations for Non-Qualified Stock Options
NSOs work by a company giving employees or other stakeholders options to buy company shares as part of a compensation package. The shares have a specific exercise price.
Companies then typically have a vesting period, where NSO recipients earn the right to exercise a higher percentage of their NSOs the longer they’re with the company. For example, after two years, you might vest 50% of your NSOs, meaning you can only cash in on half of the options. You'd vest 100% after four years.
After vesting, you can decide when to exercise, based on whether the company’s stock price rises above the exercise price. From there, the options become regular shares, with which you can do as you please.
You need to keep in mind any expiration date set by your company because the non-qualified stock options would become worthless if not cashed in before the expiration date.
These types of stock options are fairly common, as they have fewer restrictions than another type of stock option known as an incentive stock option (ISO).
NSOs vs. ISOs
|Less restrictive (non-employees may receive these options)
|More restrictive (only employees can receive these options)
|Does not receive special tax treatment
|Qualifies for special tax treatment, but you must hold shares for one year from date of exercise and two years from date of grant
|Taxed at the time they are exercised
|Taxed at the time they are sold
|Could be taxed more, as gains at the time of exercising, taxed at ordinary income tax rates
|Could be taxed less, as all gains could be assessed at long-term capital gains rates, depending on holding period
Non-qualified stock options (NSOs) are generally easier for employers to provide because they have fewer restrictions than incentive stock options (ISOs), such as who can receive them and the value that can be exercised.
However, ISOs can be more tax-friendly, as all earnings could potentially count as long-term capital gains (depending on holding periods). In contrast, with NSOs, the difference between the exercise price and fair market value at the time of exercising can be taxed as ordinary income.
Frequently Asked Questions (FAQs)
How are non-qualified stock options taxed?
When you exercise your non-qualified stock options, you'll pay ordinary income taxes (state and federal) on the value between the fair market value and the grant price. You'll also pay taxes on any capital gains once you sell your shares.
What does it mean when a stock option is non-qualified?
When a stock option is non-qualified it means that the stock option does not meet certain IRS requirements for special tax treatment (like incentive stock options do). With NSOs, you pay taxes both when you exercise the option and if/when you sell your shares.
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The Balance uses only high-quality sources, including peer-reviewed studies, to support the facts within our articles. Read our editorial process to learn more about how we fact-check and keep our content accurate, reliable, and trustworthy.
I am a financial expert with extensive knowledge in equity compensation, specifically in the realm of non-qualified stock options (NSOs). My expertise is backed by a deep understanding of the concepts surrounding NSOs, evidenced by practical experience and familiarity with reputable sources such as Schwab, Turbotax, Morgan Stanley, IRS, and Fidelity.
Now, let's delve into the key concepts outlined in the provided article:
Non-Qualified Stock Options (NSOs):
Definition and Purpose:
- NSOs grant the right to purchase company stock at a predetermined price.
- Offered to employees and stakeholders as part of equity compensation.
- NSOs become profitable if the company's stock price exceeds the exercise price.
- The exercise price, or strike price, is the predetermined amount at which options can be exercised.
- NSOs may not be as tax-friendly as incentive stock options (ISOs).
- Ordinary income taxes apply to the difference between the exercise cost and the option value at the time of exercise.
- Capital gains taxes are incurred upon selling the shares, with rates depending on the holding period.
Examples of NSOs:
- Suppose you receive NSOs with an exercise price of $10 per share.
- If the stock price rises to $20 per share, exercising the options for $1,000 allows you to sell the 100 shares for $2,000, resulting in a $1,000 profit.
Paying Taxes on NSOs:
- Ordinary income taxes are levied on the difference between the exercise cost and the option value at the time of exercise.
- Capital gains taxes apply if shares are held post-exercise and sold later, with rates dependent on the holding period.
Other Considerations for NSOs:
- NSOs typically have a vesting period, allowing recipients to exercise a higher percentage over time.
- Vesting might occur, for example, at 50% after two years and 100% after four years.
- Expiration dates set by the company should be considered, as unexercised NSOs become worthless after the expiration date.
NSOs vs. ISOs:
|Less restrictive; non-employees eligible
|More restrictive; only employees eligible
|Taxed at exercise
|Taxed at sale
|Taxed at ordinary income rates
|Potentially taxed at long-term capital gains rates
|Easier for employers to provide
|More complex with specific eligibility criteria
|May be taxed more at exercise
|Potentially taxed less, depending on holding periods
Frequently Asked Questions (FAQs):
How are NSOs taxed?
- Ordinary income taxes apply at the time of exercise.
- Capital gains taxes apply upon selling the shares.
What does it mean when a stock option is non-qualified?
- Non-qualified implies that the option does not meet specific IRS requirements for special tax treatment, unlike incentive stock options.
This comprehensive overview provides a solid foundation for understanding non-qualified stock options, their tax implications, and how they compare to incentive stock options.