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.

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.

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.

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.

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.

Frequently Asked Questions

Here are some frequently asked questions about non-qualified stock options.

  • Does the employer receive a tax benefit? 

The amount of the bargain element that the employee reports as ordinary income is generally deductible as a compensation expense.

  • What taxes does the employer need to withhold? 

The employer must treat the bargain element as if it was a cash salary payment made when the option is exercised. Withhold standard payroll taxes, such as FICA and income tax, on the amount of the bargain element. For example, if the employee has a $75,000 annual salary and exercises an option with a $5,000 bargain element, you withhold taxes as if they made $80,000 that year, and they report $80,000 in income on their tax return.

  • Can the employer restrict stock options?

​​Yes. In addition to clawback provisions, you may be able to set limits on whether shares can be resold in the open market or reserve a right of refusal.

  • Do you have to be a public company to issue stock options?

Private companies can issue stock options as long as they are otherwise in compliance with applicable securities regulations.

Talk to a Lawyer

To learn more about whether a non-qualified stock option plan is right for your business and to get help setting it up, find a lawyer on UpCounsel. UpCounsel has a directory of qualified, on-demand business and securities lawyers who can help you grow your startup.