What are Nonqualified Stock Options?

This is part 3 in a series on equity compensation. You can find Part 1 here and Part 2 here. This article is a more indepth look at nonqualified stock options. 

Refresher: What are Nonqualified Stock Options

Nonqualified stock options are a common feature of compensation packages. Just like incentive stock options, they give you the right to purchase a set number company shares at a set price and at some point in the future. 

Also like incentive stock options, nonqualified stock options let companies to tie compensation to performance of the company. In this way, nonqualified stock options (and incentive stock options) align the incentives of employees with their companies.

Nonqualified Stock Option Vesting

Nonqualified stock options typically vest proportionally over a period of 3 to 5 years. You may exercise your options after they become vested. Only when you’ve exercised your options will you be taxed. 

Note that becoming vested in your nonqualified stock options does not mean they become taxable; after all your options may never be exercised if the company stock price dropped below the exercise price. In this case you would never owe income taxes because you never would have realized any income.

Nonqualified Stock Option Expiration

In most cases, you have 10 years from the grant date of the options to exercise them. This assumes you stay employed with the company; if you no longer work for the company, you likely have less time to exercise your options. Consult your employee stock option plan document if you are thinking about leaving a company with vested nonqualified stock options.

If your nonqualified stock options expire or you leave the company before they vest, you will lose that value permanently. 

Nonqualified Stock Options Taxation

Unlike incentive stock options, nonqualified stock options are treated like W-2 income (including Medicare and Social Security taxes) when exercised. Simply having nonqualified stock options is not a taxable event but after you exercise them, you will owe taxes.

The income that you pay taxes on, is called the “bargain element”. The term “bargain element” refers to the difference between the market price of the stock and the strike price of the options times the total number of shares.

Any subsequent gains or losses on the stock after exercising the options and paying income taxes are treated as capital gains or losses. This means you need to hold the shares for at least 1 year to receive long term capital gains treatment. However, be aware that the gain (or loss) for capital gains taxes is the difference between the market price at exercise and the market price when you sell your shares; i.e. you are not “double taxed” on the shares you already paid W-2 income taxes on. 

Simplified Example of Nonqualified Stock Option Taxation: 

Let’s say you are a single wage earner in the 22% marginal tax bracket; you have nonqualified stock options for 100 shares at $25/share. After 4 years, you exercise your options when the company stock market price is $50/share. You will have a gain of $2500.00 and pay taxes of 22% (income) + 7.65% (Medicare/Social Security) = $741.25.

If you then sell the shares for $55/share after 1 year, you will owe capital gains on ($55 – $50)*100 or another $500 gain ($75.00 at a 15% long term capital gains rate). 

Cashless Exercises of Nonqualified Stock Options

Since many people don’t have the cash required to purchase their company’s shares at the exercise price (or the resulting taxes) they use something called a “cashless exercise” or a “sell to cover”. 

In a cashless exercise, a third party lender (usually a large bank who handles the company’s options) steps in to provide the cash to purchase the shares at the exercise price before selling them in the market at the market price and returning the net proceeds (minus a small fee) to the employee.

Example of a Cashless Exercise of Nonqualified Stock Options:

You have nonqualified stock options to buy 1,000 shares of your company’s stock. The nonqualified stock options have an exercise or strike price of $10/share; the company’s stock price is currently $100/share. 

Since you don’t have $10,000 in cash to purchase the shares or the ~$28,485 (24% marginal rate + 7.65% Medicare and Social Security) you decide to do a cashless exercise and immediately sell.

You go to the bank that handles your nonqualified stock options and request to exercise your options and immediately sell your shares. The bank uses $10,000 of it’s own money to purchase the shares at $10/share and immediately sells those shares in the market at $100/share. Next the bank then withholds 24% (your marginal income tax rate) + 7.65% (Social Security and Medicare) as well as a small fee for facilitating the transaction. 

Finally, the bank then credits you $61,5150 ($90,000 x (1 – (.24+.0765)) = $61,515).

If you enjoyed this article about nonqualified stock options, check out this broad overview of employee stock options, or this article about incentive stock options.

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