Everything you need to know about non-qualified stock options
What are Non-qualified Stock Options (NSOs)?
Non-qualified stock options (NSOs) allow employees to buy a company’s shares at a fixed price (known as the strike price), once the company releases it on the grant date (the date stock options are given to the employees).
The stock options will be priced at a fair market value when the grant is issued at that time. This means that once the vesting period is over, the strike price will be the same as the fair market value when the NSO was granted.
For instance, if the stock is priced for £50 on the grant date, the employee will be able to purchase the stock in the future (with expectations that the value of the stock has increased) at the same price of £50.
However, the rights over the stocks purchased can only be used after the vesting period is over, and therefore, employees would have to wait until you can exercise the options. They also have a deadline for exercising these options.
Here are some ways you can exercise your stock options:
1. Exercise and Hold (Cash Exercise) – This is purchasing the stock options using cash at the strike price and regaining your cash once you sell your shares.
2. Sell-to-Cover (Cashless) – The alternative method to using cash. This is immediately selling enough shares to cover the cost of exercising including commissions, applicable taxes, and any other fees. You can then either keep or sell the remaining stock.
3. Exercise and Sell (Same Day Sale/Cashless Exercise) - Immediately exercising and selling your shares. You can only receive net proceeds once the cost of exercising, commissions, applicable taxes, and fees have been covered.
Taxation on NSOs
Employees will still have to pay income tax on the difference with the fair market share price and the exercise price (profit made); subject to federal, state, and local income taxes as well as payroll taxes. After acquiring the options, the employee would have the freedom to either sell the shares or keep them.
However, when proceeding with the ‘Exercise and Hold’ method, if you sell after holding the shares for one year or less; you will be taxed on the difference between the fair market price and exercise price, and the sale price will be taxed as a short-term capital gain (or loss)
When you sell the stock options after holding for a year or more, you will be taxed on the difference between the fair market price and exercise price, and the sale price will be taxed as a long-term capital gain (or loss). This will also be applicable for the ‘Sell-to-Cover’ method.
Glossary
Here’s a glossary to help you gain a better understanding of the keywords we’ve used throughout the article
Stock Option: The right to buy a specific number of shares of a company’s stock in the future, at a contractually specified price (Strike Price).
Strike Price: The price of your stock options that you can purchase, specified in your stock option grant.
Grant Date: Initial date that NSOs are given to you
Stock Option Grant: Specifies the maximum number of shares that you can purchase
Vesting Schedule: A waiting period until you obtain full rights of the asset and can exercise your stock options.
Expiration Date: If the stock options have not been exercised by the specified deadline, you lose all the stock options. (This is normally around 10 years)
Fair Market Price: The cost that an asset would put up for sale on the open market.
Calculating the prospective value of NSOs
You can also calculate the potential net value of your stock options by using the equation below.
Number of Shares x (Company Share Price – Exercise Price) = Net Value of Option
Advantages and disadvantages of NSOs
Advantages
Increased income - it allows you to buy stocks at a lower price than the fair market value and allow you to gain profit from it.
Flexibility - You have full control over how to exercise your stock options once the vesting period is over
Cashless - You may not need cash to purchase stocks as there are alternative cashless methods
Post-employment – The stock options can still be exercised even after you leave the company if you haven’t surpassed the expiration date
Disadvantages
High Tax - tax incurred from the profit made once exercised could be steep as it is considered as annual income. Also, you will be taxed as soon as you exercise and sell it
Risk – It is not guaranteed that the stock prices will increase and that you will gain profit from it
Limitations with exercise methods – Cashless exercise could also mean losing significant profits for lower-income employees; having to sell stock options immediately. With cash exercise, having cash upfront may not be affordable for some.
Summary
Non-qualified Stock Options (NSOs) is equity compensation method used by businesses
You have the freedom to exercise the stock options however they want
You will be taxed at exercise and sale
If stock options are held for a year or less, the NSOs will be taxed as short-term capital gain
If the stock options are held for a year or more, the NSOs will be taxed as long-term capital gain, with the rates ranging from 0 – 20%
There is a time frame on when you could start exercising your options, and once the vesting period is over, options must be exercised before the specified deadline.
We hope that article has been informative, if you seek any further advice, please do not hesitate to contact us. To stay up-to-date and informed on the latest in UK tax advice, subscribe to our newsletter.
