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Stock options have become a popular way for companies to reward and retain employees, as well as to compensate non-employee directors and other service providers, with company stock. There are two types of stock options: incentive stock options (ISOs) and nonqualified stock options (NSOs). While both types of stock option plans give the holder the right to purchase shares of the underlying common stock at a predetermined price, known as the exercise price (or sometimes referred to as the strike price or grant price), they differ in their tax consequences.
In this blog, we will discuss the type of options that is an NSOs in detail, including what they are, how they are different from ISOs, and how they are taxed.
What are Non-Qualified Stock Options (NSOs)?
A non-qualified stock option is a type of stock option that does not qualify for special tax treatment under the U,S Internal Revenue Code. NSOs are typically offered to non-employee directors, consultants, and other service providers, as well as to employees who are not eligible for ISOs.
NSOs are called “non-qualified” because they do not meet the criteria set forth in the tax code for ISOs. To be considered an ISO, the option must meet certain requirements, such as the exercise price must be equal to or greater than the fair market value of the underlying stock on the date of grant, and the holder must hold the stock for at least one year from the date of exercise and two years from the date of grant. If these requirements are not met, the option is considered a NSO.
How do NSOs work?
NSOs work similarly to ISOs, in that they give the holder the right to purchase a specified number of shares of the underlying stock at a predetermined exercise price. The exercise price, also known as the strike price, is agreed upon at the time the option is granted, and is typically set at the fair market value of the stock on the grant date.
The holder of a NSO has the right to exercise the option at any time up until the option’s expiration date. Upon exercise, the holder acquires the underlying stock at the exercise price, regardless of the current market value of the stock.
Taxation of Non-Qualified Stock Options
One of the biggest differences between NSOs and ISOs is the way they are taxed. When an employee exercises an NSO, the difference between the exercise price and the fair market value of the underlying stock on the date of exercise is treated as taxable compensation income, and is subject to federal income tax, Social Security tax, and Medicare tax withholding.
For example, if an employee is granted a NSO with an exercise price of $10 and the fair market value of the underlying stock on the date of exercise is $20, the employee will recognize $10 of taxable compensation income. This income is subject to federal income tax, as well as Social Security tax and Medicare tax, which are withheld from the employee’s paycheck at the time of exercise, in accordance with their ordinary income tax rate.
In addition to the federal income tax, Social Security tax, and Medicare tax withholding, the employee may also owe state and local income taxes on the compensation income. The amount of state and local taxes will depend on the employee’s state and local tax laws that factor into typical payroll taxes for the employee.
It is important to note that while the employee is responsible for paying the federal income tax, Social Security tax, and Medicare tax on the compensation income, the company may also be subject to employment tax obligations on the compensation income.
The employer may be required to pay the employer’s portion of the Social Security tax and Medicare tax, as well as unemployment tax and workers compensation insurance, on the compensation income recognized by the employee. In addition, the company may also be required to pay a tax on the compensation income under the Federal Insurance Contributions Act (FICA) and the Federal Unemployment Tax Act (FUTA).
The taxation of NSOs can also have implications for the company. For example, if the company grants a large number of NSOs and a significant number of employees exercise their options, the company may be faced with a substantial tax bill. Additionally, if the stock price decreases after the options are exercised, the company may be faced with a loss, which could negatively impact its financial position.
Finally, there's vesting. Ever wonder why multi-millionaire coders stay at Facebook or Google for so long? Because a bargain element the company has over the employee is the vesting schedule. As an option holder in an employee stock purchase plan, you don't typically get all of those shares dumped on you immediately. It generally happens over a sustained, rolling period of time that continues your incentive to stay on with the company and do a good job. If the company gave you shares of the company right off the bat, there would be very little incentive for you to continue working hard because you've already secured the bag with your employee stock options. The exercise of the options over a vesting period allows companies to keep you attached to the desk in a phenomenon known to corporate drones as "the golden handcuffs."
In summary, NSOs incredibly complicated when attempting to view these as a taxable event. You have to content with taxes from all angles, and they're not necessarily written into the tax code in a visually pleasing way. While they are a type of stock option that do not qualify for special tax treatment under the U.S tax code typically offered to non-employee directors, consultants, and other service providers, as well as to employees who are not eligible for ISOs, you should contact a licensed tax professional to help you decode what exactly you might owe.
When an employee exercises a NSO, the difference between the exercise price and the fair market value of the underlying stock on the date of exercise is treated as taxable compensation income and is subject to federal income tax, Social Security tax, and Medicare tax withholding, as well as potentially state and local income taxes. The company may also be subject to employment tax obligations on the compensation income.
It is important for both employees and companies to understand the tax implications of NSOs and to carefully consider the potential consequences before granting or exercising these options. In some cases, it may be more advantageous for the employee to receive other forms of compensation, such as restricted stock units, or for the company to consider offering ISOs instead of NSOs. In either case, it is recommended to consult with a tax professional to determine the best course of action.