How Nonqualified Stock Options Work

Key Takeaways

• Nonqualified stock options (NSOs) are flexible equity compensation tools that can be issued to employees and non-employees.
• Unlike incentive stock options (ISOs), NSOs are taxed at exercise as ordinary income, with additional capital gains tax possible on later appreciation.
• NSOs can be a strategic tool for startups and growing companies to reward and retain key talent without immediate cash outlays.
• They come with specific tax implications for both the granting company and the recipient, including withholding requirements.
• Companies can design NSO plans with vesting schedules, exercise methods, and expiration terms tailored to business goals.
• Early exercise and 83(b) election strategies may impact how and when tax is paid.
• It's important to understand how NSOs affect ownership, taxes, and long-term planning.

Non-qualified stock options give you an alternative way of compensating employees. They also give employees a sense of ownership that builds loyalty and encourages them to work harder.

Non-Qualified Stock Options: What Are They?

A non-qualified stock option gives employees the right to purchase company stock at a predetermined price. There are several key elements to a stock option.

• Grant date: The date when the employee receives the option to buy the stock.
• Exercise price: The price at which the employee can buy the stock from the company. The idea is that the stock's value will later rise and the employee will be able to buy it at a discount.
• Expiration date: The latest date that the employee can exercise the option. If they don't do so, they lose the option.
• Clawback provision: You may reserve the right to cancel the option. A common reason for a clawback is when the employee leaves the company before a set period of time.
• Bargain element or compensation element: The difference between the exercise price and the market value of the stock when the employee exercises their option. The employee pays taxes on this amount. This will be reported on your wages on your Form W-2 the year you exercise the options. The amount is treated like compensation income, and you will owe income tax, social security tax, and medicare taxes
• Withholding: A company is required to withhold a certain amount of cash to cover federal and state income tax withholding and the employee's share of employment taxes as well. The amount paid as income tax withholding will be a credit against the tax the employee owes when reporting income at the end of the year, but the withholding may not cover the full amount of tax since it is an estimate of the actual tax liability.

How Nonqualified Stock Options Work

Nonqualified stock options give recipients the right to buy company stock at a fixed exercise price, typically equal to the fair market value at the time of the grant. These options do not qualify for the special tax treatment available to incentive stock options (ISOs), but they provide broader flexibility in who can receive them—including consultants, advisors, and board members.

Key components of how NSOs work include:

• Vesting Schedule: Most NSOs vest over time or upon achieving performance milestones. Recipients cannot exercise unvested options.
• Exercise Methods: Employees can typically exercise NSOs using cash, a stock swap, or a cashless method involving same-day sale.
• Expiration Terms: NSOs usually expire 10 years after the grant date or within a set period after termination of service (often 90 days).
• Transfer Restrictions: Most NSOs are non-transferable, except by will or intestacy, to ensure control over ownership transitions.

What Is the Difference Between Qualified and Non-Qualified Stock Options?

There are two key differences — who the stock can be issued to and the tax treatment.

Qualified stock options, also known as incentive stock options, can only be granted to employees. Non-qualified stock options can be granted to employees, directors, contractors and others. This gives you greater flexibility to recognize the contributions of non-employees.

Qualified stock options may also qualify for special tax treatment. If eligibility and holding period requirements are met, the bargain element is taxed as a capital gain to the employee.

For non-qualified stock options, the bargain element is treated as ordinary income to the employee. However, you have fewer obligations with regard to IRS and SEC compliance and reporting.

Tax Treatment of Nonqualified Stock Options

Nonqualified stock options are taxed in two stages:

1. At Exercise:
   • The "bargain element" (market price minus exercise price) is treated as ordinary income.
   • This amount is reported on the employee’s W-2 and subject to income and payroll tax (Social Security and Medicare).
   • The employer must withhold applicable taxes and also receives a compensation deduction.
2. At Sale:
   • Any appreciation in the stock value after exercise is treated as capital gain.
   • If the stock is held for more than one year post-exercise, gains are long-term; otherwise, they are short-term.

This tax structure can significantly impact the timing of exercise and holding decisions, especially for employees in high tax brackets.

Why Are Non-Qualified Stock Options Important?

Non-qualified stock options are important for three reasons.

• Reduce current compensation expenses.
• Share the risks associated with a growing business.
• Give your employees and partners a vested interest in promoting your growth.

Strategic Benefits for Employers

Employers often favor nonqualified stock options because they:

• Align Interests: NSOs motivate recipients to grow the company’s value, aligning interests between stakeholders and contributors.
• Extend to Non-Employees: NSOs can be granted to a wider range of service providers, including independent contractors and board members.
• Offer Tax Deductibility: Employers receive a tax deduction equal to the amount of income reported by the recipient at exercise.
• Preserve Cash: NSOs provide meaningful compensation without upfront cash outlays, which is particularly advantageous for early-stage companies.

Reasons to Consider Using Non-Qualified Stock Options

Non-qualified stock options are generally used for the following reasons.

• Provide increased compensation when you can't afford to raise salaries.
• Recognize the contributions of key employees.
• Avoid the complexity of incentive stock options.
• Issue stock options to individuals who aren't eligible for qualified stock options.

Reasons to Consider Not Using Non-Qualified Stock Options

You may want to consider avoiding non-qualified stock options in the following situations.

• As a total substitute for cash compensation. Inadequate cash salaries may hinder your recruiting.
• To give your employees favorable tax treatment with qualified stock options.
• To preserve equity for future financing, to bring in other key employees, or to leave yourself with an adequate share of the company.

Common Risks and Drawbacks

While beneficial, NSOs come with challenges:

• Tax Timing: Employees owe tax at exercise even if they don’t sell the shares, which may lead to liquidity issues.
• Complexity in Valuation: Companies must ensure they follow IRS 409A valuation rules to avoid penalties.
• Dilution of Ownership: Exercised NSOs increase the total number of outstanding shares, diluting existing ownership.
• Market Risk: If the value of the stock declines after exercise, the employee may face a loss, having paid taxes on a higher value.

Additional Advantages of NSOs

Beyond flexibility and cost savings, NSOs offer:

• Customizable Plan Design: Employers can set vesting schedules, performance triggers, and post-termination rules that fit organizational goals.
• Early Exercise Options: Some plans allow employees to exercise unvested options early, which can help start the capital gains holding period sooner.
• Recruitment Tool: NSOs are powerful incentives in competitive markets, especially when startups can’t match high salaries.
• Ownership Stake Without Control: Granting NSOs provides an equity interest without voting rights unless exercised.

Examples

Assume that your company is worth $10 per share when you grant a non-qualified stock option at a $10 exercise price. One year later, your value is $20 per share. Employees can do the following:

• Exercise and immediately sell. Pay you $10 per share to exercise their option. Immediately sell their stock for $20 per share. They immediately have $10 per share in ordinary income.
• Exercise, hold for longer than one year, then sell. Exercise their option. Hold the stock for another 18 months at which time they sell it for $25 per share. The bargain element is $10 ($20 fair value minus $10 exercise price) and is taxed as ordinary income on the date the option is exercised. When they sell the stock, they will also have a $5 long-term capital gain on the difference between their selling price ($25) and the value on the exercise date ($20).
• Exercise, hold for less than one year, then sell. Assume the same facts as above except the stock is held for less than one year. The $5 gain becomes a short-term capital gain.
• Nothing. They pay no money, receive nothing and have no tax consequences.

Employees can exercise their option even if the value has fallen below the exercise price. This may happen if they are near the expiration date but believe the value will increase in the long-term. They must still pay the full exercise price to exercise the option, but will not be taxed on exercise because the bargain element is negative.

Caution: If you set the exercise price below the fair market value on the grant date, employees must immediately pay tax on this amount.

Early Exercise and 83(b) Election Considerations

Some NSO plans permit early exercise before vesting. In these cases, employees may consider filing an 83(b) election, which allows them to:

• Pay ordinary income tax on the bargain element at the time of exercise.
• Start the capital gains holding period earlier.
• Avoid additional ordinary income tax as the stock vests (assuming no further appreciation).

Important: The 83(b) election must be filed with the IRS within 30 days of exercise. If the stock loses value or the employee leaves before vesting, they could be taxed on income they never fully realize.

Frequently Asked Questions

1. Who can receive nonqualified stock options?
   NSOs can be granted to employees, independent contractors, advisors, and board members—unlike incentive stock options, which are only for employees.
2. How are nonqualified stock options taxed?
   NSOs are taxed at exercise as ordinary income on the bargain element and may be taxed again at sale if the stock has appreciated further.
3. Can NSOs be transferred or sold?
   Generally, NSOs are non-transferable and cannot be sold, except through inheritance or divorce settlements, unless the plan allows otherwise.
4. What is a 409A valuation and why is it important?
   A 409A valuation determines the fair market value of company shares. Setting the exercise price below FMV can lead to penalties under IRS Section 409A.
5. What happens to my NSOs if I leave the company?
   Typically, you have a limited window (often 90 days) to exercise any vested NSOs after termination. Unvested options usually expire immediately.

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