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Non-qualified stock options

Lesson in Course: Finance at work (advanced, 6min )

We have non-qualified stock options, but what are they?

Companies will offer stock options as equity compensation to attract employees, which can be valuable if we work for the next big company. 

Our stock options are valuable if the current stock price (FMV) is higher than the strike price value of our stock options. This difference is often called a "spread," which increases over time if the company grows in value.

This is a payoff diagram. Read more about them here.

Companies can offer two types of stock options: incentive stock options (ISOs) and non-qualified stock options (NSOs). NSOs are usually only granted when ISOs are not available. Any employee, contractor, consultant, and board director can receive them. They aren't as preferable because they don't have tax benefits the way ISOs do.

NSO Taxes

Since NSOs don't qualify for favorable tax treatment, we usually pay more taxes on the money we make from them.

Unlike ISOs, we pay taxes twice with our NSOs. 

  1. When we exercise the option, we pay income taxes on the difference between the stock price and the strike price, even if we don't sell the stock.
  2. We pay capital gains when we eventually sell. The gains are taxed as long or short-term capital gains depending on the length of time that passed since we exercised.

The chart below shows the difference.

When we exercise our NSOs, this exercise gets reported to the IRS as income regardless of us being able to share the sells for cash. The "income" we made will show up on our W-2.

W2 Example

Strike price: $0.20

FMV: $30

Shares of NSO exercised: 1000

Amount of income reported on our W2: $29.80 x 1000 = $29,800

 
 

 

when nso seems like iso

Regularly exercising our NSOs will guarantee a tax bill; however, early exercising can make the taxes we owe seem like ISOs.

Some companies allow us to early exercise our options, meaning we can exercise all of our shares before they vest. If we exercise early, the stock price and the strike price will probably be the same. Since there isn't a difference, we wouldn't owe any taxes on exercise, and any future value would be taxed as capital gains.

Actionable ideas

Having a plan for exercising our NSOs helps prevent surprise tax bills. The lesson about NSO exercise and sales tax dives deeper into what to expect.

Since NSOs have no preferred tax treatment, early exercising is even more important for this type of stock option. We can also read more in the lesson about early exercising.

We should also talk to a tax advisor if we're considering early exercising.

Glossary

non-qualified stock option / nso

A type of stock option offered by companies as equity compensation that doesn't have any tax benefits

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