Companies can issue compensation in many ways in addition to traditional salary and bonus. For example, there are profit sharing contributions, 401(k) plan matching, and various types of stock options and restricted stock grants.
Incentive stock options, non-qualified stock options, and other types of stock grants are all treated differently. You need to understand how they all work from a tax standpoint if you own them.
What are non-qualified stock options?
Non-qualified stock options are also known as non-statuatory stock options, NSO’s, or NQO’s. They give the owner the right to buy shares of their employer’s stock for a certain price within a certain period of time.
Non-qualified stock options are quite different than ISO’s, or incentive stock options. They do not qualify for the preferential tax treatment that qualified incentive stock options do. This is because NQO’s don’t meet the strict requirements that incentive stock options do.
How non-qualified stock options differ from incentive stock options
When you exercise incentive stock options, no taxable income is reported. With non-qualified stock options, additional taxable income is created when the options are exercised. This will boost your income tax liability immediately.
Also unlike incentive stock options, your company may grant your non-qualified stock options at a price lower than current market price. ISO’s are always granted at the current market price.
The amount of taxable income created is the difference between the exercise price and the market value when exercised. This is called the “bargain element”.
The additional income is reported in the year the non-qualified stock options are exercised. The good news is if you decide to hold the stock after exercising the non-qualified stock options, you will establish a new cost basis.
Exercising non-qualified stock options
There are no taxes due when you’re granted the non-qualified stock options. Let’s say your company grants you 100 shares at $2.00 per share. No taxes are due until you exercise the options.
When you exercise the 100 options, you must pay $200 to get the shares. This $200 becomes your cost basis.
Now let’s assume the stock is trading at $10.00 per share. Your $200 is immediately worth $1,000. The difference in the cost and the value is your taxable gain.
The gain is taxed at ordinary income rates just like you earned it while working. It’s also immediately taxable in the current tax year whether you hold the shares or sell them.
While your cost basis is $200, any future growth will be taxed as if you’d bought the shares the day you exercised the options at $10 per share. This means your new cost basis is $1,000. It also means you may ultimately qualify for long term capital gains treatment if you hold the shares more than one year.
In order to exercise, most companies expect the employee to pay the cost of the exercise plus the amount of withholding. The tax withheld however, will be a credit on your tax return.
What if I don’t have the money to pay the cost of the options and withholding?
If you don’t have the capital to exercise your vested non-qualified stock options, you may be able to enlist the financial help of your broker. Some custodians will allow you to do what’s called a “cashless exercise”.
In a cashless option exercise, you essentially borrow the capital from your broker to pay for the shares of stock. You then simultaneously sell the shares on the open market and repay your broker the capital you borrowed.
In some cases, you can also use currently owned shares of your company stock to exercise the non-qualified options. Of course, the simplest way to exercise is just to pony up the cash required!
Should you exercise now or hold for later?
Why would you exercise now? If you feel confident your company stock will do very well, you may want to pay the cost to exercise the options and pay the withholding now.
This strategy allows you to lock in a lower cost basis. Eventually (and hopefully) you’ll be able to sell appreciated shares at a higher price for long-term capital gain rates. If you hold the non-qualified stock options and the stock rises, you’ll pay ordinary income tax rates on a larger amount.
But what if you think your company stock will do poorly? You may also want to exercise and sell now if you don’t have high confidence in your company stock. If you feel the prospects are poor for future stock growth, you may be better exercising the non-qualified options as they vest, then simultaneously selling the shares you bought. While you’ll be paying the ordinary income taxes now, you will have locked in your current profits in anticipation of a future decline.
Other reasons for exercising your non-qualified stock options and selling now are if you have a better alternative for investment capital and if you are overweight in your company stock and need to diversify.
Are non-qualified stock options yours immediately?
Non-qualified stock options frequently have a vesting schedule tied to them. Commonly, 25% of the options granted will vest each year and can be exercised and sold by the employee.
For example, if 1,000 non-qualified stock options are granted to an employee at $2, the employee can exercise and sell 250 shares of the stock each year for 4 years until the entire grant is exhausted.
Non-qualified stock options can be tricky
Make sure you speak with your financial advisor and tax accountant before you make any decisions on exercising your non-qualified stock options. The rules are highly complex, and you may leave a lot of money on the table if you don’t handle your options properly.