This is the second post in a series on employer stock programs.
Non-Qualified Stock Options (NSOs, or sometimes called NQSOs) allow employees to purchase shares of company stock over a defined period of time. Similar to Incentive Stock Options (ISOs), NSOs are included in company benefits packages to help attract and incentivize talent. You may receive NSOs when you first start a new job, or as a bonus later on.
How NSOs Are Like ISOs
Just like ISOs, you receive a grant of NSOs with a specified price per share, and you can choose to exercise your options at that price once they have vested. The hope is that the shares’ market value will increase between the date you were granted shares and the date you exercise them, so you can essentially buy company stock at a discounted price.
The shares you receive aren’t worth anything until they are vested. They often vest completely over three to four years. A typical vesting schedule might be: at one year from your start date 25% of the options vest and then 1/36 every month over the next 3 years. This means that the longer you stay at the company, the more likely you are to have vested shares.
How the Tax Treatment Is Different
Unfortunately, NSOs lack the favorable tax treatment bestowed upon ISOs. With ISOs, you aren’t taxed when you exercise your stock options — only when you sell your shares later on. With NSOs, the difference between the exercise cost and the current market value (also known as the compensation element) is taxed as ordinary income as soon as you exercise the option.
The compensation element is reported on your year-end W-2 tax form. Since this is reported to the IRS, they know exactly how much you received and it’s treated exactly like your other wages. So not only is income tax due, but you’ll also pay Social Security and Medicare taxes.
The good news about NSOs is that they aren’t subject to the Alternative Minimum Tax (AMT), unlike ISOs.
Example of How NSOs Work
Let’s say you have 1,000 stock options with the ability to exercise them at $20 per share (cost to exercise = $2,000). Let’s also assume that the current stock price is $40 per share, or a current market value of $4,000. The compensation element of $2,000 ($4,000 market value – $2,000 exercise cost) is taxed at ordinary income tax rates.
What Happens When You Sell Your Shares
When you exercise your options, you have to come up with the cash to buy your shares at the exercise price. This can be tough — you may have thousands of dollars in shares available to buy. That’s a lot of money to spend at once! The upside is that, if you sell in the future at a gain, you’ll earn that money back and then some (obviously the risk here is that the shares will lose value and you’ll lose money).
The alternative is a cashless exercise. A cashless exercise happens when you exercise options and then immediately sell them by using the the shares themselves to pay for the cost of exercise. Because NSOs are taxed at ordinary income rates immediately at exercise, they make particularly good candidates for this.
Another benefit of a cashless exercise is it frees up your investing dollars to diversify into a wider range of investments, rather than keeping a large percentage of your portfolio invested in one company.
Going back to the previous example, if you sell your shares after holding them for less than a year for $5,000, you’ll owe short-term capital gain taxes on the $3,000 gain (which is the same rate as your ordinary income taxes). If you held the shares for more than a year, you’d owe the lower long-term capital gains tax rate.
How Do You Decide What to Do With Your Company Stock?
The decision to exercise NSOs, do a cashless exercise, or sell your exercised shares in the future can be complicated. It’s important to consider your overall financial picture and tax situation.
Sometimes, people have various types of company stock (such as ISOs and RSUs) with the same company. I’ve seen this happen when the company was a startup and then goes public or is acquired by a bigger company. This creates a more complex tax situation and there can be significant amount of money wasted if you don’t have a tax strategy when you’re deciding what to do with your company stock.
We recommend discussing this with a Certified Financial Planner as well as a tax professional who can help run tax projections for different scenarios. If you’ve been granted NSOs or any other type of company stock (ISOs, RSUs, or participate in an ESPP) and would like help navigating your situation, we’re here to help!