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- Non-Qualified Stock Option (NSO)
- Comparing Options: Nonqualified Stock Options Vs. Incentive Stock Options
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Non-Qualified Stock Option (NSO)
Related Content. A Checklist outlining the requirements that must be satisfied for a stock option to qualify as an incentive stock option ISO under Section of the Internal Revenue Code and receive more favorable employee tax treatment than non-qualified stock options.
An individual who exercises a non-qualified stock option must pay ordinary income taxes on the excess of the fair market value of the underlying shares on exercise over the exercise price the "spread". However, ISOs are not subject to ordinary income taxes if the shares are held for both:. An employee incurs no income tax at grant or on the exercise of an ISO although the spread is a tax adjustment item for purposes of calculating alternative minimum tax and the profit if any made on the sale of the shares is taxed as long-term capital gain.
From the employer's perspective, ISOs are less attractive than non-qualified stock options, because the employer is not entitled to a tax deduction on an employee's exercise of an ISO, if the employee meets the above holding requirements. The terms of the option must not provide that the option will not be treated as an ISO. If you exercise and hold the options on January 1, , you will have to hold the shares for at least one year to qualify for the preferential capital gain tax treatment. Capital gains tax rates vary depending on your taxable income. As of , the capital gains tax rates are as follows:.
Comparing Options: Nonqualified Stock Options Vs. Incentive Stock Options
The biggest risk with ISOs is the potential for the stocks to lose value before they can be sold, especially if you are subject to the AMT alternative minimum tax in the year that you exercise. If you sell them before waiting a full year after vesting otherwise known as a disqualifying disposition , then you lose the long-term capital gains tax benefit that makes them so attractive in the first place. NSOs are different.
Regardless of whether you hold your stock options or sell them, the spread the difference between the exercise price and grant price is counted as part of your earned income and taxed at your ordinary income rate. NSOs taxes are withheld at the time of exercise.
This earned income is also subject to payroll taxes, which include Social Security and Medicare. Social Security payroll taxes are equal to 6.
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If you hold onto your ISOs, you will need to report the difference between the grant price and exercise price as part of your alternative minimum taxable income. Insiders of publicly traded companies may need to hold onto the stock after it has lost significant value. By the time you may be able to sell the shares, they could be worth less than the AMT tax due on the original exercise. Careful planning with a team of financial experts can help individuals avoid the AMT trap and establish a robust tax and trading strategy.
Regardless of whether you receive incentive stock options or non-qualified stock options, know that both are subject to taxes and need to be accounted for when you file. The most important thing to remember is that once you exercise your options, the result is the same—you now own stock in the company, and that stock can help you pad your financial future beyond your regular paycheck. Reach out to our team to learn how we help clients develop a strategy that integrates executive compensation into their broader financial plan.
Employees can substantially increase their income as stock price increases, but this expense is borne by the open market, not the employer. Improved employee morale and engagement. Any benefit can raise employee morale, but NSOs are particularly effective, because they offer employees the chance at higher income and a feeling that their actions can impact their earnings. Flexibility in terms of tax impact. Because the timing of exercising NSOs is flexible, you can minimize the tax impact by deferring the exercise and sale of options until it is financially prudent.
From the company standpoint, there are also tax deductions available for the amount of spread employees report as income. Disadvantages of NSOs There are three important disadvantages of NSOs for companies and employees to consider before exercising non-qualified options: Larger tax burden. Because NSOs are treated as ordinary income, exercising options is a significant tax event and can even push an employee into a different tax bracket.
Potential risk. There is no guarantee that stock prices will rise, which means that options can turn out to be useless or a loss, lowering productivity and morale in addition to the financial impact. Exercise issues. If cash is required upfront to exercise options, this can exclude many employees from affording the benefit. Even cashless stock exercises can be prejudicial against lower income employees, as they miss out on potential capital gains when they are required to sell exercised shares immediately.
Priori Pricing Depending on your needs, the cost of creating a stock option plan can vary significantly.