Qualified vs. non-qualified stock options -- the difference centers on tax treatment. Qualified stock options are generally treated very favorably in terms of federal taxes.

Qualified vs. Non-Qualified Stock Options

When an individual has a stock option, it means that they have the ability to purchase a set number of company stock shares at a price that has been predetermined. These purchases can only take place after the completion of the vesting period. A type of stock option exists known as an incentive stock option. The benefit of this option is that it can provide beneficial federal tax treatment. 

When a stock option does not qualify as an incentive stock option, it is called a non-qualified stock option (NQO). NQOs do not offer the beneficial tax treatment that is available with incentive stock options.

Incentive stock options are preferred because of their tax treatment. When these options are used, there is no acknowledgment of income. However, if the stocks are sold immediately after the option is exercised, they do not receive special taxation, putting them on equal footing with NQOs. 

To receive the tax benefits of incentive stock options, the company employee would need to hold on to the stocks after exercising their options. This is a common practice when a company is preparing to go public. Qualified stock options is another name for incentive stock options.

When a qualified stock option is exercised and results in a profit, this profit will be taxed at 15 percent, which is the standard rate for the capital gains tax. This is also considerably lower than the income tax rate. Profits made from NQOs are taxed as normal income, which is a definite drawback. However, these stock options are much more flexible in who they can be provided to, which is a distinct benefit. They also have more exercising options than qualified stock options.

While employees may prefer qualified stock options, non-qualified stock options are more beneficial to the company, as there is a shorter waiting period before they can be deducted. Several commonalities between qualified vs. non-qualified stock options can be found.

Employees should be careful about weighing the benefits and drawbacks of stock options. For instance, employees need to purchase both NQO and qualified stock options. This is different than restricted stock units, which can be awarded. If you are interested in exercising your stock options, it's important to understand the tax implications and the function of these options.

If your stock options are in a private company, then you will be exposed to much more risk when exercising your options than you would with a publicly listed company. Some risks associated with stock options include:

  • The ability of a private company to limit when it's possible to sell stock shares, possibly making it difficult for you to receive a return on investment.
  • Keeping hold of too much stock, which can make you vulnerable to volatility if the stock rapidly loses value.
  • Not knowing if your stock will retain its value after a company acquisition or merger.

However, if you have pre-IPO stock options, you may be able to make a great deal of money once vesting has occurred.

How to Use Non-Qualified Stock Options

When employees hold non-qualified stock options, they would need to pay the standard income tax rate on the difference between what they paid for the stock and what the stock was worth after being sold. If a company grants its employees non-qualified stock options, the employees are able to purchase a certain number of shares at a fixed price during a time period chosen by the company. 

A company might choose to offer its employees non-qualified stock options for several reasons. First, NQOs could be offered instead of traditional compensation. Second, the company may want to inspire a feeling of loyalty in their employees.

When pricing non-qualified stock options for employees, companies will almost always use what those shares' market value would be if they were publicly available. Once the options have been granted, employees must exercise them before the designated expiration date. Failing to do so will result in the employees losing their options. 

If you need help understanding qualified vs. non-qualified stock options, you can post your legal needs on UpCounsel's marketplace. UpCounsel accepts only the top 5 percent of lawyers to its site. Lawyers on UpCounsel come from law schools such as Harvard Law and Yale Law and average 14 years of legal experience, including work with or on behalf of companies like Google, Menlo Ventures, and Airbnb.