A non-qualified stock option (NSO or NQSO), is a form of stock-based compensation that can be offered to an employee as part of their package. Many smaller companies employ the use of NSOs in lieu of salary increases or bonuses because they won’t need access to immediate cash.
NSOs can be a great tool for employees, but in order to make the most out of them, you have to know how they work and how to best use them. That is what we are going to look at today.
What are NSOs?
Non-qualified stock option awards give employees the choice to purchase company stock at a set price, often below the fair-market value. Non-qualified stock options differ from incentivized stock options (ISOs) because they do not meet the Internal Revenue Code requirements for ISOs. This actually makes NSOs more manageable and simpler to understand.
How do NSOs work?
As you evaluate your NSOs, it is important to know a few key terms to help you decide when you can and should exercise your options:
Grant date: This is the first day when the company grants permission for their employees to purchase their set number of stocks.
Exercise date: This date marks the occasion when the employee exercises their right to purchase the stocks at the agreed-upon price. It also marks the first time that the NSOs will be taxed.
Exercise price: The price that the employee is able to purchase the stock. Usually, the price is set below the fair market value, which offers an incentive to employees. However, when the grant date comes be sure to evaluate the market value of the stock. Sometimes it can fall below market value and you wouldn’t want to purchase the stock for more than it is worth.
Sale date: The day the employee sells their stock. This is also the second time that the stock option will be subject to tax.
Offering period: The amount of time that an employee has to sell the stock. There is no mandated time limit so it can shift based on the company. Once the offering period is over, the employee forfeits their options.
If you are offered NSOs as part of your compensation package, you will be able to purchase a set amount of stock at a particular time, often for a lower price than the market value. This can be beneficial to the strength of your portfolio and can help you maximize the benefits of your position.
It is important to check with your employer about their right to withhold or take away your NSOs, otherwise known as a clawback provision, in the case of mergers, layoffs, or retirement.
How are NSOs taxed?
Non-qualified stock options are taxed at two phases of the process. The first phase is the exercise date or the day when the employee purchases the stock. You will need to pay ordinary income tax on the difference between the grant price and the market value, otherwise known as the spread. This means that federal, state, and payroll taxes will be withheld no matter what on the transaction.
The second time that these options get taxed is upon the sale of the stock. After you pay ordinary income on the spread when you exercise your options, you will also need to pay capital gains tax when you decide to sell the stock. If you hold the stock for at least a year, you will be able to qualify for long-term capital gains tax, which is a much more favorable rate. Let’s look at an example to help.
Marty’s company offered him $1,000 NSOs at an exercise price of $12 per share. Once Marty’s options have vested, he decides to exercise his shares when the price is at $25. Marty would need to report $13,000 on his W2 from the spread. He then decides to hold onto the stocks for another 3 years at which point he sells them for $40 and has to report a long-term capital gain of $15,000.
NSOs are a great tool for young start-up companies to attract and retain new talent. When used wisely, they can be a wonderful asset to your financial plan. Understanding how they work, when you can use them and the tax requirements will give you a well-rounded picture of how they fit into your financial plan.
Stocks options are good tools to help you build your wealth. Are you interested to see how you can maximize the stock options in your employee compensation package? Give us a call, we would love to work with you to create a plan that helps you reach your goals.