Non-Qualified Stock Options: Basic Features and Taxation
Two main types of stock options are offered to employees of technology companies: nonqualified stock options and incentive stock options. This article focuses on the basic features and tax treatment of nonqualified stock options.
Nonqualified stock options commonly go by the names nonquals, NSOs, or NQSOs. The term “nonqualified” reflects tax law terminology and means the option does not qualify for special income tax treatment. In contrast, incentive stock options, or ISOs, receive more favorable tax treatment under certain conditions.
Basic Features
A nonqualified stock option represents a legal agreement between you and your employer. It defines the terms under which the company is willing to sell its stock to you. Specifically, the option gives you the right to purchase a certain number of shares at a fixed price for a defined period. This purchase price is known as the exercise price or strike price and typically equals the value of the company’s stock on the grant date.
When the company’s stock price exceeds the exercise price, the option value equals the stock price minus the exercise price, multiplied by the number of option shares. In this case, the option is considered “in the money.” For example, if you can buy 1,000 shares at $0.10 per share and the stock trades at $10 per share, the option value equals $9.90 per share, or $9,900 total.
If the stock price falls below the exercise price, the option has no intrinsic value and is considered “underwater.”
Once the option term expires, often after 10 years or upon leaving the company, the option loses all value. Some plans include a short post-termination exercise window during which you may still exercise vested options.
To exercise your option, you notify the company and pay the exercise price for the shares purchased. For instance, exercising 1,000 shares with a $0.10 strike price requires a $100 payment. Stock options provide the right, but not the obligation, to buy shares. The decision of whether and when to exercise remains entirely up to you.
Stock options typically vest over time to encourage employee retention. Vesting determines when you earn the right to exercise the option. Plans commonly vest monthly over four or five years, often with a one-year cliff. After the cliff, vesting continues monthly. As each portion vests, you gain the right to purchase a proportional number of shares. For example, completing two years of a four-year vesting schedule allows you to exercise options on 500 of 1,000 shares.
After exercising vested options and purchasing shares, you may choose to hold or sell them. Selling typically requires a public market, such as following an initial public offering or while working for a company with publicly traded stock. In some situations, private company shares may also be sold. Because exercising nonqualified stock options triggers taxable income, many individuals may choose to sell enough shares to cover the tax liability. Another common strategy involves a same-day exercise and sale, where shares are exercised and sold immediately.
In the event of an acquisition, option shares may convert into shares of the acquiring company or be cashed out for their value.
“When should I exercise my company stock options?” Let’s face it, this can be a complicated decision. You might be wondering if you should hold onto the stock after buying it or sell it right away. There’s also the question of timing – when’s the best moment to strike? Not to mention the tax implications!
Taxation
When you exercise a nonqualified stock option, the difference between the stock’s market price and the exercise price is treated as ordinary income. Employers typically report this amount on your paystub. Receiving the option itself does not create a tax event. Taxation occurs only upon exercise. While exercising NSOs does not directly trigger alternative minimum tax (AMT), the additional income may increase AMT exposure in some cases.
Once you purchase the shares, your cost basis equals the stock price on the exercise date. When you later sell the shares, standard capital gains rules apply. Holding shares for more than one year qualifies any gain for long-term capital gains rates. Selling sooner results in taxation at ordinary income rates.
Some pre-IPO companies allow early exercise of stock options before vesting. Early exercise combined with a Section 83(b) election can convert a portion of ordinary income into capital gain. With an 83(b) election, taxation occurs at exercise before appreciation and before vesting. If you then hold the shares for at least one year, most of the appreciation may qualify for long-term capital gains treatment rather than ordinary income taxation.
If you hold nonqualified stock options, it is important to understand key features such as the exercise price, vesting schedule, early exercise provisions, post-termination grace period, and expiration date. You should also understand the tax implications of exercising options and selling shares as part of your broader tax planning.
Savant Wealth Management provides holistic wealth management services including financial planning, equity compensation planning, investment management, tax planning, and others, on a fee-only basis and as a fiduciary, acting in clients’ best interests. If you’d like to explore how we can help you build and protect your wealth, schedule a complimentary consultation.
This is intended for informational purposes only. You should not assume that any discussion or information contained in this document serves as the receipt of, or as a substitute for, personalized investment or tax advice from Savant. Please consult your investment or tax professional regarding your unique situation.
Bruce R. Barton
Managing Partner / Financial Advisor
CFP®, CFA®, MBA