Both the number of shares and the time frame of share purchase are usually predetermined in the nonqualified stock option plan or agreement. These stock options are referred to as nonstatutory stock options by the US Internal Revenue Service (IRS) and are commonly abbreviated as NSO or NQSO.
Nonqualified stock options are a ready choice for most companies as they can be issued to a wide variety of recipients including employees, contractors, lawyers, consultants, and all other stakeholders who are nonemployees of the company. Additionally, unlike qualified stock options that can only be issued by corporations, NQSOs can be issued by corporations, limited liability companies (LLCs), and partnerships.
See also: Restricted shares
Nonqualified stock options explained
As stated earlier, the nonqualified stock options give their holders the right to buy the shares of the option’s granting entity at a future date. Although the holder has a right to purchase the shares, they are not obligated to exercise their right. Thus, as long as they do not exercise this right, they do not actually own any shares in the company.
If you chose to purchase the shares by exercising your right, you have the option of paying in cash for the shares or selling part of the shares to cover the purchase. If you chose the former, it is known as a cashless exercise. However, not all granting entities offer the cashless exercise option.
The date on which the nonqualified stock option was granted is known as the grant date. The price at which you will purchase the shares is known as the exercise price, strike price, or grant price.
Typically, before you can purchase the shares, they have to vest; meaning that you have to fulfill the conditions attached to the nonqualified stock option. There might be a vesting schedule for the nonqualified stock option too.
The vesting schedule specifies what percentage of the shares you can purchase (exercise) per time. If you are allowed to exercise all the shares associated with the stock option at once, it means the stock option has a cliff vesting schedule. If on the other hand, you can only exercise in part annually, then the nonqualified stock option has a graded vesting schedule.
Generally, nonqualified stock options have a specified date after which if the shares associated with them are not purchased, they become forfeited. This date is known as the expiration date. The expiration date for NQSOs varies from one company to another and is usually stated in the stock option agreement.
Furthermore, even if you no longer work with or provide services to the company that granted you the nonqualified stock option, you still have the right to exercise your NQSOs provided that they are already vested and the expiration date has not been reached. The period within which you must exercise your right to purchase the shares after leaving the company is known as the post-termination exercise period (PTEP).
Nonqualified stock options are regulated by section 409a of the Internal Revenue Code. This section imposes a twenty percent (20%) excise tax when some operation rules in the section are violated by the nonqualified stock option holder.
Taxes for nonqualified stock options
- Tax at Exercise
- Tax at sale
Tax at Exercise
Although there is no tax event for nonqualified stock options when they are granted or when they vest, they are taxed once you exercise your right to purchase them regardless of whether you decide to hold them or sell them immediately. Nonqualified stock options are taxed on the spread between the exercise price and the Fair Market Value (FMV). This spread is normally taxed at the ordinary income rate.
For employees, the tax on the spread between the exercise price and the Fair Market Value (FMV) is usually withheld by the granting entity at the time of exercise. The withheld tax amount for up to one million dollars ($1,000,000) spread is twenty-two percent (22%) while thirty-seven percent (37%) is withheld if the spread is over one million dollars. It is however important to note that even though part of the tax is withheld, the employee still needs to pay up the remaining taxes themselves to the Internal Revenue Service (IRS)
In addition to the ordinary income tax paid on nonqualified stock options, the spread on it is also liable to payroll taxes which include Medicare and Social Security taxes for the stock option holder. The payroll taxes usually amount to an additional 7.65% for those whose earned income is below one hundred and thirty-seven thousand, seven hundred dollars ($137,700). 6.2% accounts for Social Security taxes while 1.45% accounts for Medicare. For those whose earned income is above $137,700, the payroll taxes they pay is only Medicare which is an addition of 1.45% to their ordinary income tax.
For nonemployees with nonqualified stock options, their taxes are not withheld by the company, instead, they are usually given a form 1099 which enables them to handle their tax payments themselves. Companies that grant NQSOs also have to pay payroll taxes, which include Federal Unemployment Tax (FUTA), Medicare, and Social Security taxes.
Furthermore, you gain a tax deduction when you exercise your stock option early. This tax deduction is because there is likely to be no difference between the exercise price and the Fair Market Value. However, the early exercise option has to be part of the nonqualified stock options agreement or has to be subsequently approved by the company’s board of directors.
Tax at sale
After exercising your nonqualified stock option, you now own shares of the company that granted you the NQSO. Now, if you decide to sell these shares, you will have to pay tax on the difference between the exercise price and the current Fair Market Value (FMV) of the shares. This tax is usually taxed at the personal income tax rate if you chose to sell immediately after exercising your stock option.
When you hold the shares for some time but still sell within a year after you exercised your nonqualified stock options, you will be subject to a short-term capital gain tax rate. In order to enjoy a lower tax rate on the spread, you will have to hold the shares for more than a year after you have exercised. This way, you will be subject to the low long-term capital gains tax rate.
Related: ISO vs NSO stock options
Nonqualified stock options vs qualified stock options
Although both nonqualified and qualified stock options are used as incentives, they have some key features that differentiate them. We shall outline these differences within the table below
|Nonqualified stock options||Qualified stock options|
|These stock options are less restrictive as they can be granted to employees and other stakeholders||These stock options are restrictive because they can only be granted to employees|
|Do not qualify for most of the favorable tax treatments||Qualifies for more favorable tax treatments|
|The difference between the exercise price and the fair market value is taxed at the time of exercise||There is usually no tax event at the time of exercise|
|They are usually taxed at the time of sale at the personal income tax rate.||They are taxed at the long-term capital gains rate at the time of sale if they were held for up to two years after they were granted and a year after exercising|
|The expiration date of these stock options is dependent on the agreement terms||The expiration date of these stock options is usually ten years after they were granted|
|Nonqualified stock options can be exercised even after the termination of appointment provided they are already vested||Most qualified stock options have to be exercised within three months after the termination of the appointment|
|They can be granted by partnerships, limited liability companies, and corporations.||They are only granted by corporations|
|They are subject to payroll taxes||They are not subject to payroll taxes|
|Nonqualified stock options are regulated by section 409a of the Internal Revenue Code||Qualified stock options are regulated by section 422 of the Internal Revenue Code|
|These stock options have no cap on the amount that can be exercised yearly||These stock options have a cap on the yearly exercise amount which is $100,000|
See also: ISO vs NSO – which is better?
Nonqualified stock options are generally granted as incentives for services rendered. In order for the recipient to derive the maximum benefits from them the time of exercise and sale are very important as they influence the overall amount to be paid as taxes. It is additionally pertinent to consult a tax advisor before either exercising or selling your nonqualified stock options. Even though a tax advisor may not be able to predict the exact gains you will make on the stock options in the future, they can aid you in taking the necessary steps to minimize your tax liability on your nonqualified stock option.