Non-qualified stock options (NSOs) are not eligible for favorable tax treatment. When you exercise NSOs, you pay taxes when you exercise (purchase shares) as well as when you sell those shares.
What are non-qualified stock options? #
Some employers offer their workers shares in their company as part of their compensation package. In general, there are two options for this: qualified stock options and nonqualified stock options.
Non-qualified stock options (NSOs or NQSOs) allow employees to purchase stocks in their employing company at a predetermined price. This is usually set at the current market value of the stock at the time of the offer. Since share prices are expected to increase over time, employees can often acquire stock options for a discount.
Grant #
When you receive the NSO, you can’t use it to purchase stocks right away. You still need to wait until the options to vest. On the Grant Date, your employer will determine the Exercise Price (aka the Strike Price) of your NSO.
For the purposes of this note:
Exercise Price = Strike Price
Your stock options strike price is usually equal to the FMV of the company’s stock on the day the option is granted.
It’s easy for public companies to determine their strike price: all they have to do is look at what the stock is currently trading at. That’s the price that people are willing to pay on the open market. If Apple, for example, is trading at $200 per share, their FMV is $200 that day.
If the company is private, then we need to rely on the 409A valuation. A 409A valuation is the fair market value of the common stock of a private company as valued by a third-party appraiser.
Exercise #
After the vesting period has elapsed, you can exercise the NQSOs.
The simplest exercise method is the use of cash to pay the exercise cost.
It is also fairly common to include a so-called clawback provision, meaning that the company reserves its right to cancel the option, e.g. when the employee leaves the company before a predetermined date.
Example of an NQSO Cash Exercise #
You have an NQSO to purchase 100 shares of your company’s stock at an exercise price of $10/share. When the stock reaches $15 per share, you exercise your entire option using cash. To complete the exercise, you write a check to the company for both the total exercise price of $1,000 and the taxes on the $500 spread.
- Exercise cost = 100 shares x $10/share = $1,000 but
- FMV at the time of exercise is $15/share –> 100 shares x $15/share = $1,500
- Spread is calculated = $1,500 – $1,000 = $500
- $500 extra income –> this is taxed as ordinary income
A cashless exercise is an exercise-and-sell transaction in which you do not have to come up with the cash needed to pay the exercise price and the amount required for tax-withholding. Instead, you simultaneously exercise your option and sell the stock.
You may be able to exercise early but make sure to also file the 83(b) election within 30 days of doing so.
Taxes #
Pay ordinary income tax on the difference between the Fair Market Value at the time of exercise and the Strike Price when you exercise your options. So, if you pay $1 to purchase each share and the 409A value is $5, then you’re taxed on the $4 spread.
The spread is subject to income tax and FICA taxes (Social Security/Medicare taxes).
However, if you exercise your stock and then hold it for some time then you might be subject to capital gains tax.
Pay capital gains tax on (Sale Price – FMV at the time of exercise) when you sell the shares. So, if you exercise the shares when the 409A value is $5, then sell those shares for $50, then you’ll be taxed on the $45 capital gain.
Depending whether you held the shares for over a year before selling them, you’ll either pay long-term capital gains or ordinary income tax rates on them.
