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Non-Qualified Stock Options Explained (Plus What They Mean for Your Company’s Taxes)

Written by Clint Freeman on October 29, 2021

It’s important to attract quality candidates and incentivize your key workers. One way of doing that is by offering equity-based compensation in the form of non-qualified stock options.

What are employee stock options?

A stock option gives an employee the right to buy a set number of shares in a company for a fixed price, also known as the “strike price.”

That price is usually determined by the fair market value when the company grants the options. If the value of those shares increases between the time the options are granted and the date that they exercise those options, the employee can make money on the difference, also known as “the spread.”

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The timing of taxation of stock option depends on whether the option has a readily ascertainable fair market value (FMV) at the time of the grant. If the FMV is readily ascertainable, then the stock option is taxable at the time of the grant.

The option generally has to be actively traded on an established securities market to have a readily ascertainable FMV. For most privately held companies, the FMV of the option is not readily ascertainable.

There are two types of stock options:

Incentive stock options (ISOs)

Incentive stock options give employees the opportunity to buy stock in the company at a discounted price.

ISOs qualify for special tax treatment if the employee meets both of two requirements:

  • ISO stock must be held at least two years after the grant date, and
  • also held at least one year after exercise.

The employee does not have to pay taxes when they receive the option grant or exercise the option. Instead, the employee reports taxable income only when they sell the stock.

When the ISO stock is sold after meeting the two requirements, the difference between the sales price and the strike price is a long-term capital gain to the employee.  If the requirements are not met, then the bargain element is ordinary earned income to the employee.

Non-qualified stock options (NSOs)

Non-qualified stock options can go to employees as well as independent contractors, partners, vendors and other people not on the company payroll.

NSOs don’t qualify for favorable tax treatment for the recipient but allow the company to take a tax deduction when the options are exercised.

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Tax Treatment of Non-Qualified Stock Options

Stock acquired from exercising a non-qualified stock option is treated as any other investment property when sold. The employee’s basis is the amount paid for the stock, plus any amount included in income upon exercising the option.

The holding period for determining whether the sale is short-term or long-term begins when the option is exercised. The capital gain or loss is long-term if the employee holds the stock for more than one year; otherwise, it’s a short-term capital gain or loss.

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When the option is exercised, regardless of whether the recipient holds the stock or sells it, the spread is counted as part of their taxable compensation and taxable at ordinary income rates.

As a result, the employer must withhold federal income tax, Social Security and Medicare tax at the time of exercise. The employer must also include that income in the employee’s W-2 wages at year-end.

Non-qualified stock options are more common than incentive stock options because the company can take a tax deduction for compensation expenses when the employees exercise their non-qualified stock options. They may also have fewer obligations with regard to IRS and SEC compliance and reporting.

Non-Qualified Stock Options: An Example

To illustrate, say the company grants an employee 10,000 shares of non-qualified stock options with a strike price of $1 per share. The stock isn’t actively traded on an established securities market, so the non-qualified stock option isn’t taxable at the time of the grant.

The employee exercises the non-qualified stock options when the stock price is $5 per share, paying the company $10,000 ($1 for each option exercised). The $4 difference between the strike price and the stock price is included in the employee’s taxable compensation, subject to ordinary income and payroll taxes.

The employee may sell the shares immediately (assuming there is a market to do so). There should be no additional tax due; the employee would be able to sell them for $5 per share, which is also their basis.

However, if the employee holds onto the stock for 18 months (i.e., more than 12 months) and sells it for $6 per share, they would have to recognize a long-term capital gain of $10,000 — their $60,000 sales price less their $50,000 basis.

Where Should I Go with Other Questions About Equity-Based Compensation?

To learn more about offering equity-based compensation, be sure to check out our accompanying article, Profits Interest Grants Explained and listen to our podcast episode, How Can My Company Offer Equity-Based Compensation? (Profits Interest Grants and Unqualified Stock Options).

There are clear business advantages to offering non-qualified stock options, but you need to understand what you’re getting, what you’re giving up, and carefully comply with IRS regulations to avoid unexpected consequences.

Connect with a Warren Averett advisor for help properly structuring and accounting for your non-qualified stock options and ensure that the after-tax value of the option is what you expect it to be.

Listen in on the discussion about how profits interest grants work in this podcast episode.

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