Nonqualified Stock Options: Tax, Features & Benefits

Nonqualified Stock Options (NSOs) are a widely used form of equity compensation offered by companies to employees, contractors, consultants, and other service providers. 

After years of working with venture firms and investing in early-stage startups, I’ve observed that NSOs are a powerful tool for companies looking to attract and retain talent. They also play a significant role in compensation strategies across various industries.

NSOs grant the holder the right to purchase company stock at a predetermined price, known as the exercise or strike price. This price is typically set at the market value of the stock at the time of grant. 

The terms of NSOs are outlined during the grant phase, including the following:

• Vesting schedule
• The expiration date of the options, 
• Restrictions on selling the stock after exercising the options

These elements are critical for both the company and the recipient, as they establish the timeline and conditions for utilizing the options. NSOs offer an opportunity for recipients to benefit from the company’s growth while navigating specific tax implications and strategic considerations.

Key Features of Nonqualified Stock Options

One of the defining features of NSOs is the vesting period. This is the time frame during which the recipient must wait before they can exercise their options. 

As per Cake Equity, vesting periods typically range from one to four years, during which the employee gradually earns the right to purchase the shares. This phased approach can serve as a powerful incentive for recipients to remain with the company, fostering loyalty and aligning their interests with the company’s success. If an employee leaves the company before the vesting period is complete, the unvested options usually expire.

Once the vesting period is complete, the recipient gains the right to exercise their NSOs. Exercising options involves purchasing the company stock at the predetermined exercise price, also known as the strike price. 

As per Chris Dohrmann of Global Shares, “Exercising stock options is a key milestone in a stock option’s life cycle. If you don’t exercise your options before they expire, you’ll lose them. ”

Hence, at this stage, recipients face a critical decision: to hold onto the shares or sell them immediately. This choice carries significant financial and tax implications:

• Holding the Shares: If the recipient decides to hold the shares after exercising, any subsequent profit or loss from selling the stock is considered a capital gain or loss. If the shares are held for more than a year, they may qualify for lower long-term capital gains tax rates, which can provide a tax advantage.
• Selling the Shares: Selling the shares immediately after exercising locks in the profit (if any) but subjects the spread—the difference between the market value of the stock and the exercise price—to ordinary income tax. This ensures liquidity for recipients but foregoes potential future gains.

Tax Implications and Reporting Requirements for NSOs

NSOs come with distinct tax considerations and reporting requirements that recipients need to understand to effectively manage their financial obligations.

Tax Treatment of NSOs

One advantage of NSOs is that they are not taxed at the time of grant, meaning recipients do not face immediate tax liabilities upon receiving their options. Instead, tax implications arise when the options are exercised.

Tax Implications at Exercise

When NSOs are exercised, the spread between the fair market value (FMV) of the stock and the strike price is treated as ordinary income. 

To calculate this, multiply the number of shares exercised by the difference between the market value at the time of exercise and the grant price. The resulting income is reported on the employee’s tax return and is included in overall compensation income.

This ordinary income is subject to federal income tax, state income tax, and payroll taxes such as Medicare and Social Security. Tax rates vary depending on the individual’s tax bracket, ranging from 10% to 37% at the federal level. 

Employers typically withhold payroll taxes at the time of exercise, but recipients should ensure they have sufficient funds to cover any additional liabilities.

Capital Gains Tax After Exercise

After exercising NSOs and holding the shares, any subsequent profit or loss from selling the stock is treated as a capital gain or loss. The nature of this gain or loss depends on how long the stock is held after exercise. 

Shares held for more than a year may qualify for long-term capital gains tax rates, which are generally lower than ordinary income tax rates. These rates range from 0% to 20%, depending on the individual’s income level.

NSO Reporting Requirements

Understanding and meeting reporting requirements is crucial for managing NSOs effectively. When NSOs are exercised, the difference between the stock’s market price and the strike price is considered ordinary income and must be reported on the recipient’s tax return. 

The company granting the NSOs does not typically issue any form to detail the ordinary income realized from the exercise. For employees, this income would be reported on their W-2. For non-employees, such as contractors or consultants, this income would be reported on the following:

• Form 1099-NEC (as of 2020)
• Form 1099-MISC (before 2020)

When the shares are eventually sold, recipients must report any capital gains or losses. The cost basis for these calculations is typically the exercise price plus any ordinary income recognized at the time of exercise. State taxes may also apply, adding another layer of complexity to tax planning.

NSOs vs Incentive Stock Options (ISOs)

Understanding the differences between NSOs and Incentive Stock Options (ISOs) is crucial for anyone navigating finance careers such as growth equity, venture capital, or private equity. These stock options are tools companies use to attract and retain talent, but they come with distinct characteristics that impact both the company and the option holder. 

Below is a comprehensive comparison that highlights their key differences and implications.

Eligibility

One of the primary distinctions between NSOs and ISOs lies in who can receive them.

• NSOs: These can be granted to a broad range of recipients, including employees, directors, consultants, and advisors. This flexibility makes NSOs a versatile tool for companies aiming to incentivize diverse contributors.
• ISOs: In contrast, ISOs are exclusive to employees, making them a more restricted option for equity compensation.

Tax Treatment

Tax implications are a significant consideration when evaluating stock options:

NSOs

When exercised, the spread between the exercise price and the fair market value (FMV) of the stock is treated as ordinary income, which can result in a higher tax burden. This income is subject to federal income tax, state income tax, and payroll taxes such as Medicare and Social Security. 

Any profit or loss upon selling the stock is taxed as a capital gain or loss, depending on how long the shares are held.

ISOs

These offer special tax treatment under the U.S. Internal Revenue Code. If certain conditions are met the spread at exercise may be taxed as a long-term capital gain, which generally has lower tax rates. An example of this condition is holding the shares for more than two years from the grant date and one year from the exercise date. 

However, ISOs can trigger the alternative minimum tax (AMT), adding complexity to tax planning.

Regulatory Compliance

Both NSOs and ISOs must adhere to SEC guidelines, but there are notable differences:

• NSOs: These face fewer regulatory restrictions, simplifying the process for companies issuing them. This simplicity can be a significant advantage for startups and smaller firms with limited resources.
• ISOs: These are subject to stricter regulations, including limits on the total value of options that can be granted to an individual in a single year. This makes ISOs a less flexible choice for companies but provides additional protections for employees.

Pros and Cons of NSOs

NSOs provide various benefits that make them appealing to both companies and recipients. Below are the key advantages that highlight why NSOs are a popular choice for equity compensation.

• Flexibility: NSOs can be tailored to meet specific needs, allowing companies to design compensation packages that align with strategic goals and individual contributions.
• Broader Eligibility: NSOs incentivize not only employees but also consultants, advisors, and other non-employees critical to a company’s success.
• Simpler Issuance: With fewer regulatory hurdles, NSOs are easier to issue, especially for startups and smaller firms.

Despite their benefits, NSOs also come with notable drawbacks that should be carefully considered. The following points outline the main disadvantages associated with NSOs:

• Larger Tax Burden: The ordinary income tax treatment at exercise can significantly increase tax liability.
• Potential Risk: If the company’s stock underperforms, the options may become worthless, affecting employee morale.
• Exercise Challenges: Exercising NSOs often requires upfront cash, which may disadvantage lower-income recipients.

How Companies Use NSOs for Compensation

NSOs are a powerful tool for companies looking to attract and retain talent, and they play a significant role in compensation strategies across various industries. For finance professionals, understanding how companies use NSOs can provide valuable insights into corporate compensation practices and help in evaluating potential investment opportunities.

Compensation Tool

NSOs can be an integral part of an employee’s compensation package, offering a potential long-term financial benefit if the company’s stock performs well. 

For example, the COO of a tech company, Edward, was granted 10,000 NSOs three years ago with a strike price of $5 per share. When he exercised his options, the FMV of the stock had risen to $9 per share. This resulted in a taxable spread of $4 per share, or $40,000 in total ordinary income. 

To cover the tax liability and exercise costs, Edward opted for a “sell-to-cover” transaction. He exercised all 10,000 options and immediately sold enough shares to cover the exercise cost and tax withholding. Edward’s company withheld these amounts from the proceeds of the stock sale. The remaining shares were deposited into Edward’s brokerage account.

This scenario illustrates how NSOs can provide financial benefits, but also highlights the immediate tax implications upon exercise. Edward will need to report the $40,000 as ordinary income on his tax return, which will be included in Box 1 of his W-2. He may owe additional taxes depending on his overall tax situation and may need to make estimated tax payments to avoid penalties.

Industry Use

In industries like technology, where innovation and talent are critical to success, NSOs are commonly used to attract top talent. As a lecturer at the Wharton MBA program on product management, I’ve seen firsthand how NSOs can be used effectively in technology companies to attract top talent and drive innovation.

For example, Dale and Darlene Sullivan, experienced marketing consultants in the tech industry, have each been granted 5,000 nonqualified stock options (NSOs) by a growing software company they’ve been advising. The options were granted with a strike price of $10 per share and a four-year vesting schedule with a one-year cliff.

After two years, when 50% of their options have vested, they decide to exercise 2,500 options each. At the time of the exercise, the company’s stock is trading at $25 per share. This created a taxable event for each of them, which yielded a total taxable ordinary income of $37,500.

This $37,500 will be reported as ordinary income for each of them. Since they are not employees but consultants, TechVision Inc. will report this income on Form 1099-NEC (Box 1) rather than a W-2. The company is not required to withhold taxes, so Dale and Darlene will need to make estimated tax payments to cover their tax liability.

They will also need to pay $25,000 each (2,500 × $10) to exercise their options. They decide to do a “cashless exercise” for a portion of their options, selling 1,000 shares immediately to cover the exercise cost and estimated taxes, while keeping the remaining 1,500 shares.

This scenario illustrates how NSOs function for non-employee service providers, creating a taxable event at exercise and requiring careful tax planning. 

Managing Your NSO Portfolio

Managing an NSO portfolio requires strategic planning and a clear understanding of your financial goals. By delaying the exercise of NSOs, you can defer taxation, particularly if you anticipate a rise in the stock price. 

However, this strategy carries risks, as a decline in stock price could impact your equity stake. Diversification is crucial, particularly if NSOs represent a significant portion of your net worth. This is where understanding the differences between equity options and phantom equity can be beneficial.

Working with a CPA or financial advisor can help navigate the complexities of NSO taxation and develop a personalized tax strategy. They can assist with AMT calculation, cashless exercise options, and other tax planning strategies. 

Understanding your long-term financial objectives, including liquidity events and valuation fluctuations, is essential for effective portfolio management.

International Tax Considerations and Strategies for NSOs

NSOs with international ties can be complex, especially for individuals who have worked across different jurisdictions. Here are the key complexities and strategies for effectively handling NSOs in international scenarios.

Tax Implications for International Workers

For individuals who have worked in the U.S. while holding NSOs, U.S. income taxes may apply to the spread—the difference between the stock’s market value and the exercise price. 

Non-residents who exercise NSOs while working in the U.S. must file U.S. tax returns to report this income, often using forms such as Form 8938 to disclose foreign financial assets. Residency status plays a significant role in determining tax obligations. For example:

• Non-Residents: If you’ve never worked in the U.S. and are not a U.S. citizen, you generally won’t owe U.S. income tax on your NSOs.
• Residents: Tax treaties between the U.S. and other countries can provide relief from double taxation, though understanding these treaties’ nuances is essential.

Case Studies in International Contexts

Hypothetical Example

Suppose an employee working in the U.S. is granted 10,000 shares of NSOs with a strike price of $1 per share. At exercise, the stock price has risen to $5 per share. 

The $4 difference per share ($40,000 in total) is treated as US-sourced ordinary income and subject to federal income tax, state income tax, and payroll taxes. If the employee holds the shares post-exercise and later sells them at a higher price, the capital gain is calculated based on the new sale price and is subject to capital gains tax.

Startup Employees

Startup employees with international NSOs face unique challenges, particularly with valuation changes. Exercising options early, when the FMV is close to the exercise price, can reduce compensation income and taxes. This strategy resembles an 83b election, where taxes are paid on the total fair market value of restricted stock at the time of grant instead of at vesting.

Qualified Small Business Stock (QSBS) Exclusion

If the issuing company qualifies as a small business, shares acquired through NSOs might be eligible for the QSBS exclusion. This allows recipients to exclude up to 100% of capital gains from federal taxes if the shares are held for at least five years. Consulting with a tax advisor is crucial to confirm eligibility and plan accordingly.

International Strategies

For international workers, NSOs may require splitting the spread into U.S.-sourced and foreign-sourced income. The U.S.-sourced portion is taxable and subject to wage withholding, making tax planning more complex. Common challenges include:

• Tax Deadlines: Missing deadlines can result in penalties.
• State Taxes: Overlooking state-specific tax obligations can lead to unexpected liabilities.
• Double Taxation: Leveraging tax treaties is essential to avoid paying taxes in both jurisdictions.