The Basics You Need to Know About Non-Qualified Stock Options (NSOs)
If you work for a company that offers equity compensation then you may notice, or have received, non-qualified stock options as a piece of the compensation structure. Of the two types of employee stock options, non-qualified options and incentive stock options, non-qualified stock options tend to be more prevalent.
Stock options may seem a little daunting because of the complexities and moving parts but rest assured I’m here to give you the basics on non-qualified stock options.
What Are Non-Qualified Stock Options (NSOs)?
First off, let’s define what exactly an employee stock option is:
An employee stock option is a contractual right that a company awards an employee (the “optionholder”), under a stock plan, to purchase the company’s stock at a fixed price and under a rigid timeframe.
Non-qualified stock options (NSOs) are one of the two types of employee stock options, the other being incentive stock options (ISO), and happen to be the more popular of the two.
NSOs may be granted to employees, officers, directors, contractors, and consultants.
NSOs do not qualify for special, favorable tax treatment under the US Internal Revenue Code, hence the “non-qualified”.
Remember, with employee stock options you’ll be extended an amount of options that will vest according to your employer’s specified requirements (e.g. time vesting) WITH a fixed exercise price.
Your Non-Qualified Stock Option Grant
Just like with all equity, it starts with a grant. Once you receive your NSO grant, you’ll have a good idea of the vesting timeline of your options. When in doubt, review your grant document or the summary page of your equity management platform (e.g. Carta, eTrade, Shareworks, etc.).
The date that you’re “granted” your options is also the date in which the exercise price AND your option’s expiration date is determined.
The “exercise price”, most often the company’s stock price on the grant date, is the price at which you can exercise your NSOs in order to receive shares of your company’s stock.
For example, if the fair market value of your company’s stock was $10 on the date of your grant then your exercise price would be $10 per option.
Vesting Your Non-Qualified Stock Options
Like all forms of equity, your NSOs will likely have a vesting schedule attached to it. Vesting schedules are a way for employers to try and retain key employees for a specific amount of time.
In short, vesting is the process in which you meet certain requirements set forth by your employer in order for your equity to become fully yours. Remember, until the equity is yours it’s simply a “promise” from your employer.
Vested = Yours
Unvested = Not Yours
Most often these requirements are “time-based”, or requiring you to work for the employer a specific amount of time after your grant.
Typically, you won’t vest any options until at least one-year of employment AFTER your grant but be sure to check your grant document.
Once your NSOs vest, you then have the ability to exercise them if you wish. Exercising your options largely depends on what your goals are and how your equity fits into your financial plan.
It’s important to know your personal vesting schedule so that you can develop a strategic equity plan for your NSOs.
The Expiration of Your Non-Qualified Stock Options
When you receive your grant there will also be an expiration date tied to your NSOs.
The most common duration for an NSO expiration date is 10 years from the date of grant.
HOWEVER, do your due diligence by checking your grant documents for your expiration date.
Pro Tip: Write down the expiration date for each grant in your calendar.
Do note that once your options vest that you actually have a shorter period to exercise your options. You DO NOT have 10 years until expiry from when your options vest.
If you leave your company, you’ll forfeit any unvested options. However, you typically have 60-90 days to exercise any vested options before they are forfeit.
Events such as retirement, disability, or death can trigger different rules under your company’s specific stock plan so be sure to review your company’s equity plan documents carefully.
Your Exercisable Non-Qualified Stock Options
Like I mentioned above, stock options give you the “option” to buy your company’s stock at a fixed and pre-determined price.
The hope is that the price of your company’s stock exceeds the cost to exercise your options, also called the strike or exercise price.
If this is the case then your options have real and tangible value, or are “in the money” options.
If your company’s stock price is BELOW your exercise price then your options are “out of the money” or underwater and are currently worthless (it would cost more to exercise the option than you would be able to make back by selling the stock from the exercised option).
Vested and “in the money” options require a decision from you:
Exercise the options in order to buy shares
Continue to hold the options & do nothing
Exercising Your Non-Qualified Stock Options
If you decide that you want to exercise your NSOs then you’ll have to make a couple more decisions:
Cash versus cashless exercise
Holding or selling the stock after exercise of your NSOs
Cash Versus Cashless Exercise
There are two primary ways to exercise your NSOs: using cash or performing a cashless exercise (also known as a same day exercise and sale).
Cash Exercise
A cash exercise will require you to have the cash available to pay to exercise your NSOs.
Cashless Exercise
On the contrary, a cashless exercise (aka selling-to-cover) involves the exercise of the options and the sale of the shares simultaneously so the proceeds of the sale can be used to pay for the exercise price and tax withholding. The optionholder then receives the net cash, minus any brokerage commissions/fees.
For example, you may have 1,000 NSOs that you want to exercise but don’t have the full cash available to do so. Let’s assume those options have a $10 exercise price and the current stock price is $100.
Shares Needed to Sell-To-Cover = Total Exercise Cost / Fair-Market Value (FMV) at Exercise
100 shares (sell-to-cover shares) = $10,000 (total exercise cost) / $10 (FMV of stock at exercise)
Instead of paying $10,000 to exercise the options, you could do a cashless exercise where 100 shares would be sold in order to pay for the 1,000 options to be exercised. In this scenario, you would net 900 shares after the cashless exercise minus any shares that would be sold to pay for tax withholding and commissions/fees.
The benefit is that you don’t have to pay anything out of pocket. The con is that you have less shares now.
Holding or Selling the Stock After Exercise
After you exercise your NSOs, you’ll have to determine what you’ll do with your company stock: hold the stock or sell the stock immediately (when outside of a blackout period).
Selling the stock immediately will offer you two benefits:
Reduce your concentration in your employer’s stock
Lock in gains/profits from the difference in the exercise price and the fair market value of the stock (i.e bargain element).
Holding the stock after exercise will allow you to potentially participate in further upside in the company’s stock price BUT you may also suffer from lower profits, and potentially no profit, if the company’s stock decreases.
I implore you to have an equity plan in place for how to handle your employee stock as opposed to “flying by the seat of your pants”. By doing this you will have a strategic approach that isn’t driven by your emotional or behavioral bias.
Holding and Doing Nothing with Your Non-Qualified Stock Options
Once your NSOs vest, you can simply do nothing with them and continue to hold them. By default this is what most people do because they lack a plan for their equity.
Your company’s stock will continue to fluctuate while you hold your options.
If your company’s price remains, or increases, above your exercise price then your options will continue to hold, and increase in, value.
However, if your company’s stock price decreases then your options will decrease in value and may even become valueless if the price decreases below your exercise price.
How Your Non-Qualified Options Are Taxed
No taxes are due on your NSOs until you exercise them. This means that when NSOs are granted, or even when they vest, there aren’t any tax implications.
Once you exercise your NSOs, you have a taxable event in which taxes will become due.
The great thing about employee options is that you generally get to choose when you exercise your options and are subsequently taxed. This allows for you to do some strategic tax planning before exercising your options.
When you exercise your NSOs, the “bargain element”, the difference between your exercise price and the company’s stock price on the date of exercise, is considered “compensation income” and is taxed as ordinary income.
Let’s keep the same details in the above example:
1,000 NSOs you want to exercise
$10 exercise price
$100 share price on exercise
Calculating the Taxes
Step 1: Calculate Taxable Income
Taxable Income = # of NSOs Exercised * Bargain Element
$90,000 (Taxable Income) = 1,000 (NSOs exercised) * $90 ($100 - $10)
In this case, you would have $90,000 of compensation income that would be taxed as ordinary income.
Step 2: Calculate Projected Tax Liability
Federal Tax Liability = Taxable Income * Marginal Tax Rate
$21,600 (Federal Tax Owed) = $90,000 (Taxable Income) * 22% (Federal Tax Rate)
In this example, your federal tax due would be approximately $21,600.
Do note that you’ll also owe state, Medicare, and Social Security taxes on the taxable income resulting from the exercise.
State taxes = $90,000 (Taxable Income) * (your state’s tax rate for you)
Medicare tax = $90,000 (Taxable Income) * 1.45%¹
Social Security tax = $90,000 * 6.20%²
As you can see, you’ll likely owe more tax than you think when you factor in federal, state, Medicare, and Social Security.
¹ An additional Medicare tax of 0.90% is applied to income over $200,000 for single filers and $250,000 for married filing jointly for 2023.
² Social Security tax is only paid on income up to $160,200 for 2023.
Tax Withholding and Payment of Taxes
When you exercise your NSOs, some of your shares will be sold to cover in order to meet your appropriate tax withholdings.
However, the amount withheld may not be enough to cover your full tax liability (mainly federal).
This is because the statutory withholding rate for supplemental income under $1 million is 22%. Once supplemental income exceeds $1 million the statutory rate climbs to 37% where the excess supplemental income above $1 million is taxed at.
So the big risk is under-withholding for those earning less than $1 million in supplemental income but are in the 24% marginal tax bracket or higher. This could result in a surprising tax bill come tax filing season.
So if you anticipate owing more taxes you can:
Check with your employer to see if you can increase the withholding rate on your supplemental income (more and more companies are accommodating for this)
Increase your regular withholdings to withhold more in tax throughout the year
Make quarterly estimated tax payments to cover the remaining tax owed
You’ll also want to consult with your tax professional.
If you’re looking to make quarterly estimated tax payments to cover the difference then you’ll need to set back enough cash each quarter before the due date to make these payments or sell additional shares to cover the anticipated tax.
Finally, it’s worth noting that taxable income resulting from exercised NSOs AND tax withheld will show up on your annual W-2.
After Exercise
If you decide to hold your shares post exercise then you will have another set of tax implications, capital gains or losses.
In this case, the stock’s price on the date of exercise will be the stock’s cost basis for determining any future capital gains or losses.
In the example above, the stock’s new cost basis would be $100. Here’s some scenarios of what some capital gains and losses could look like:
What Should I Do with My Non-Qualified Options?
Like all equity, it’s crucial to have a plan for what to do with it. It’s better to be proactive than reactive. With equity, the more reactive you are the costlier it tends to be.
What you should do largely depends on your goals, your circumstances, your risk tolerance, as well as many other factors.
With that being said, here are some possibilities to consider:
Exercise your options as they vest and hold onto the shares long-term.
This strategy suits those that are bullish on their company’s stock AND want to minimize ordinary income that’s recognized on the bargain element.
Exercise your options and sell the shares immediately.
This would be the same day exercise and sale that was referenced above. This suits those that want to divest from company stock with low risk and allocate the funds elsewhere (e.g. goals, reinvest in a brokerage account, or something else).
Exercise your options at, or near expiration, and selling the shares.
This is what happens the most due to those without a plan. This is a reactive approach that gives very little wiggle room for tax planning and potentially involves missing some profitable opportunities.
Wait and watch.
If your company’s stock price is currently under your exercise price then the options are currently worthless. It does not make sense to pay more than the stock is worth in order to exercise the options. At this point you may just have to wait and watch what your company’s stock price does.
Determining which route is best for you can be difficult to discern as it “depends” on many factors. Don’t hesitate to reach out to an expert if you need help reviewing your options and making a plan for your NSOs or rather equity in general.
I hope this article has been valuable to you and that you’ve learned some things about non-qualified stock options. Again, your equity arrangement is very unique to you and your company so I encourage you to spend some time reviewing your company’s equity plan documents and your specific grant documents. If that’s too much then I recommend hiring a professional to assist you with understanding your equity and creating a plan for it!
