Firms find many ways to incentivize their employees, and one popular method is to offer employees stock options. However, all ESOPs are not the same – they can be either qualified (QSO) or non-qualified (NSO). So, what is an NSO? We explain this in detail below.
What Is an NSO (Non-Qualified Stock Option)?
Non-qualified stock options (NSOs) are a type of non-cash compensation offered to employees by their firms, most often by startups.
In effect, NSOs let them purchase company stock at a pre-decided preferential rate on a date agreed to between the firm and the employee (called a vesting schedule).
One point to note about NSOs is that they do not receive preferential tax treatment.
The employee will have to pay ordinary income tax on the difference between their grant price and the exercise price as soon as they exercise the option.
In contrast, incentive stock options (ISOs), another type of ESOP, are taxed at a capital gains tax rate, which is lower than the ordinary income tax rate.
Another difference is that while NSOs can be offered to most employees, ISOs are usually given only to senior and key personnel in the organization.
What Happens When You Exercise Non-Qualified Stock Options?
The tax burden generated is the immediate impact of exercising a non-qualified stock option.
Depending on the time at which the NSOs are exercised and when the shares are finally sold, the employee will have to pay taxes calculated based on the following three concepts:
- Compensation element: Grant price * the number of shares
- Cost basis: (Exercise price – Grant Price ) * number of stocks
- Sale: Selling price * the number of securities – commissions
The compensation element is taxable at the ordinary income tax rate the same year the option exercise happens.
It does not matter whether the shares were sold that year or not. Hence, the employee may have to pay this tax out of pocket.
When the stocks are sold, only the difference between (Sale – Cost Basis) gets taxed. However, there could be three scenarios around this event.
If the sale happens the same day, the exercise price and sales price are equal. Hence the employee exercising the option merely reports the commission paid as a short-term loss, and the ordinary income tax gets applied anyway.
For sales that do not happen on the same day but within a year of the exercise date, the difference is charged as a short-term gain (or loss) and taxed accordingly.
Lastly, if the employee happens to sell the share a year after exercising the option, the difference between Sales and the Cost Basis gets taxed as per long-term capital gains tax rates.
Let us take a simple example of 10 NSO shares with a grant price of $10, an exercise price of $15, and a sale for $25.
Let the commission on the sale be $1. The three components we talked about earlier will be calculated as follows:
- Compensation Element = $10 *10 = $100
- Cost Basis = ($15-$10) * 10 = $50
- Sale = ($25-$15) * 10 – $1 = $99
Lastly, the difference between Sales and the Cost Basis becomes $49 ($99-$50).
The $100 compensation element gets taxed as ordinary income taxes in the same year as the exercise happens.
If the sale happens within the first year, the $49 amount gets taxed as a short-term capital gain, whereas if it happens afterward, the long-term capital gains tax rates will get applied.
When Should You Exercise NSO Stock Options?
Depending on your expectations from the NSOs, there could be many options for when the exercise should happen.
Below are a few strategies that can be followed, with their pros and cons.
In this case, the employee waits to exercise the option until the company’s stock reaches a target price that they have in mind.
The benefit, of course, is that a target income is reached in this case, but on the flip side, it might happen that the securities never touch the desired price.
In the second scenario, the employee will lose any potential profit they could have made whenever the share is higher than the strike price.
Create a Schedule to Exercise Options
Creating a schedule usually involves letting the stock grow in value for a few years and then periodically exercising a part of the grant (for example, 20% each year for five years).
This option spreads the income across multiple years, and therefore, it potentially lets the employee manage their tax burden more efficiently.
It also benefits them through dollar cost averaging. The security might fetch a higher average return over the long term with this method as compared to randomly exercising it at any price.
Treating Options as a Cash Bonus
Another path is to simply exercise the option as soon as it vests and sell it the same day.
The benefit of this strategy is that it eliminates all market risks. In effect, the options become almost like a cash bonus.
The downside is that the holder never benefits from capital appreciation in this scenario.
Wait Until the Last Minute
Most NSOs have a ten-year expiration date, so one strategy is to simply wait it out till the last minute and get the full benefit of share price growth over time.
Of course, this is a risky strategy since you are hoping that the share will grow continuously and the options will reach their peak potential in the final year.
There is no guarantee this will happen, and selling all stock in the final year will put a huge tax liability on your shoulders.
Minimizing Tax Liability
This approach involves finding the right time when the share’s fair market value is as near the strike price as possible, thereby giving as little tax liability as possible.
Another aspect to look at is when to sell the share – if it is held for longer than a year, the taxable income is lower because the favorable long-term capital gains tax rate kicks in.
However, this method completely discounts the option’s time value and may not give the best result if the share goes on to do well.
Lastly, none of the above methods is perfect. The correct answer depends on the individual’s risk appetite and tax-saving preferences.
Sometimes, a mix of approaches might also work out best.
Can I Sell an NSO?
NSOs cannot be traded on the market directly. They need to be exercised, and their underlying shares can then be sold.
Like all equity options, NSOs are the right to buy the company’s stock at a certain strike price.
If the shares of the firm go above this strike price, this option can be exercised to get the securities at the pre-agreed strike price, irrespective of the prevailing market price.
When Can You Sell Non-Qualified Stock Options?
Once the employee exercises their right to buy the shares, they can sell them immediately.
Since the difference between the strike price and the price on the grant date of the NSOs is taxable at ordinary income tax rates anyway, many people prefer to do this.
How Are NSO Stock Options Taxed?
As mentioned, NSOs will be taxed based on when the stock is sold after exercising the option.
If it is sold immediately, there is no additional tax liability, and whatever difference there is between the strike and exercise price is taxed at ordinary income tax rates.
On the other hand, the difference between the sale price and the exercise price will again be taxed if you choose to sell afterward.
If the stock is held for over a year, the tax applicable will be as per long-term capital gains rates, while for less than a year, the short-term capital gains rates will kick in.
Do You Pay Social Security on Stock Options?
Yes, social security has to be paid on income from stock options.
For tax purposes, the difference between the exercise price and the strike price of the NSO is treated as ordinary income.
All applicable taxes are levied on this money, which includes ordinary income tax, social security, and medicare.
Are Non-Qualified Stock Options Tax Deductible?
NSOs are tax deductible for the firm but not for the employee.
When exercised, the company can claim a deduction for compensation expenses, just like paying salaries and wages.
The employees, however, have to pay income tax.
What’s the Difference Between Qualified and Non-Qualified Stock Options?
Profits earned by exercising qualified stock options are taxed at capital gains tax rates, whereas those made on non-qualified stock options are treated as ordinary income.
Since capital gains tax rates are lower, qualified stock options could be better for the employee.
Moreover, taxes are not deducted from QSO incomes on the date when the options are exercised. The deduction only happens after the employee sells the shares.
The key difference between an ISO and NSO is that the gap between the fair market value at the grant and the strike price is taxed as ordinary income for NSOs, but no tax is applicable for ISOs.
If an employee can hold on to their incentive stock options for at least one year after exercising and two years after the grant, any profit (FMV – exercise price) is taxed at long-term capital gains rates.
However, as mentioned earlier, NSOs are more flexible regarding who they can be given to and who can offer them.
For example, only employees can get ISOs, whereas contractors and consultants can also get NSOs from a firm.
Similarly, LLCs and partnerships can also give NSOs, but only corporations are eligible to give out ISOs.
One more disadvantage to the firm in the case of ISOs is that it cannot claim a tax deduction on them, whereas the tax payout on NSOs is deductible for the company.
Employees can exercise up to $100,000 worth of ISOs in a financial year, whereas there is no such limit in the case of NSOs.
If the employee leaves the firm, ISOs must be exercised within three months. However, this restriction does not apply to NSOs.
Instead, it is decided by the employer-employee agreement at the time of joining.
Similarly, ISOs have a hard cutoff of ten years for expiry, but NSOs can be set to expire after even longer terms.
What Is Better, ISO or NSO?
From a tax point of view, ISOs are much better than NSOs.
This is because any profits that accrue are taxed at preferential capital gains tax rates as long as they are held for one year after exercising and at least two years after the grant.
However, for employees liable to Alternative Minimum Tax (AMT), the difference between the exercise price and grant price is taxable.
In such cases, ISOs are riskier because if the stock price falls, there might not be enough benefit in holding on to it for the entire year after exercising to offset the AMT.
NSOs are more commonly used than ISOs because their applicability is wider and their tax structure is less complex.
The simple rule is that any profit made till the exercise date gets taxed as ordinary income, whereas anything afterward and up to a sale is liable for capital gains tax.
There can be many strategies to maximize the benefits of NSOs, including trying to minimize the tax outlay or maximize the option’s time value.
What works best for an individual depends on their risk appetite and expectation from the options.
Between ISOs and NSOs, the former is more beneficial to the employee because they get a more favorable tax treatment.
If they can hold on to the company shares for at least a year after exercising and two years after the grant, all ISO income is taxable only at capital gains tax rates.
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