A type of stock option used by employers to compensate and incentivize employees
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A non-qualified stock option (NSO) is a type of stock option used by employers to compensate and incentivize employees. It is also a type of stock-based compensation.
Unlike incentive stock options (ISOs), which come with special tax benefits, holders of non-qualified stock options are required to pay taxes based on the price of the stock at the time when the options are exercised.
How Non-Qualified Stock Options Work
Companies offer employees non-qualified stock options with the expectation that the underlying stock price will increase in the future. NSOs are preferred by employers because they serve as both a form of compensation, as well as an incentive for employees to work harder, as they benefit from higher stock prices.
The diagram below shows what an approximate NSO timeline looks like, using the hypothetical case of Sarah, a new associate at a publicly-traded bank:
The grant date is the date at which Sarah receives her non-qualified stock options. It is important to note the price of the stock at the grant date since her gains are determined by the difference between this price and the price at which the options are exercised (typically higher).
After being granted the options, Sarah must work at the bank for a specified time period before she can vest her options and gain a “vested interest” in the company. At such a time, she can exercise her options and earn the difference.
After reaching the vesting period, Sarah must exercise her options before they expire, or she will lose the income from the options.
The section below covers further details and calculations on the value of NSOs and how they are taxed:
Taxation and Non-Qualified Stock Options
As mentioned earlier, employees are required to pay taxes on NSOs when they choose to exercise their options since exercising the options creates a reportable income. The amount that will be taxed is given by:
Taxable Amount = No. of Shares Exercised * (Market Value at Exercise – Grant Price)
In Sarah’s case, let us assume that she’s been granted 1,000 shares with a grant price of $5 each. She exercises the options one year later and sells her shares immediately at the market price of $45.
The total taxable amount is equal to $40,000 [1000 x ($45 – $5)].
Suppose that the flat income tax rate for Sarah is 30%. Therefore, the total tax she needs to pay is equal to $12,000 ($40,000 x 0.30).
Sarah may choose to pay the amount by forgoing an equal amount of shares. The total number of shares she would need to give away is equal to $12,000/$45 = 266.67, or 267 shares.
Even after giving away 267 shares in taxes, Sarah sells 733 shares worth $45 each – giving her a total income of $32,895 after taxes.
An alternative to selling her shares immediately would be holding on to them in expectation of increases in the market value. There are two types of scenarios that can result from the above:
1. Sarah holds her shares for less than 12 months before selling them
In this case, Sarah would be required to pay the short-term capital gains tax rate on the profits she has made. The rates are typically pegged to tax brackets and are equal to ordinary income taxes. The amount is given by:
Short-Term Capital Gains Tax Rate x (Current Market Value – Exercise Price)
2. Sarah holds her shares for more than 12 months before selling them
In this case, Sarah would be required to pay the long-term capital gains tax rate on the profits she made. The rates typically range between 0%-20%, depending on her income. The amount is calculated by:
Long-Term Capital Gains Tax Rate x (Current Market Value – Exercise Price)
Therefore, by holding her shares for a longer period of time, Sarah may have the chance to save on tax payments through the capital gains tax rates. However, it carries uncertainty and risk since her gains depend on the price movements of the underlying stock.
If the stock falls in value, Sarah is likely to lose a lot of her income and vice versa.
How Do Employers Benefit From Non-Qualified Stock Options?
Non-qualified stock options benefit employers in ways that are similar to all other stock options. By serving as an effective compensation method, it reduces the potential cash outflow and allows the company to retain higher cash and liquidity for other needs. It also acts as an incentive for employees – once they have a vested interest in the company, they are likely to be loyal and motivated to increase the value of the stock.
In addition to the above, the use of NSOs also allows the employers to benefit from a tax deduction equal to the amount of income from stock options declared by the receiver (i.e., employee), which is why it is preferred by employers.
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