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Nonqualified Stock Options Broken Down

Updated: November 15, 2023
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What Are Nonqualified Stock Options?

A nonqualified stock option, also known as an NSO, is a form of employee compensation offered by employers wherein the option holder pays ordinary income tax on the profit made when they exercise the shares. They can also be granted by non-employers, such as contractors or consultants. NSOs make it possible for employees to benefit in the rising value of the stock of their employer, which creates extra performance incentives.

A private company will use NSOs to incentivize employees by giving them ‘skin in the game’ in the form of stock. Unlike ISOs, NSOs can be used with contractors and consultants and not just limited to employee.

How Nonqualified Stock Options Work

Nonqualified stock options are granted through a legal agreement between an employer and employee, which outlines the terms at which the company is willing to sell you stock. NSOs are granted with the expectation the value of the stock will increase so the employee can benefit in its gain.

The options are typically priced at the fair market value of the stock when the grant is issued. In other words, if a company’s current stock is valued at $50 per share at the time of the NSO grant, the exercise price will be $50. This means the employee has the opportunity to buy stock at $50 per share in the future, when hopefully the stock is valued higher at that time. The process is buying shares in the future is also known as exercising your options. The exercise price of NSOs can be set at a higher or lower price than the fair market value, depending on the terms of the agreement.

Important Terms In Nonqualified Stock Options:

  • Number of Shares. The number of shares is the total number of NSO shares the employee is granted in their compensation package. The employee will have the option to exercise its options in the future to buy these shares.
  • Exercise Price. The exercise price is the fair market value of the shares at the time of grant, which is the price at which an employee can purchase them in the future. In the perfect world, the future value of the shares will be higher than the exercise price.
  • Grant Date. The grant date is the date the NSOs are issued to the employee, which is typically made official by signing a contract (LINK). The grant date is what the expiration date is formulated from.
  • Expiration Date. The expiration date is when the options will expire. This is typically years after the grant date.
  • Vesting Schedule. The vesting schedule outlines the time it takes for the employee to gain ‘vested interest’ in the company. In other words, an employee will need to work for a certain amount of time to be given the option to purchase the shares.

Not all employee stock purchase plans (ESPP) are the same. Below is an outline of NSOs vs other ESPPs.

Nonqualified Stock Options (NSOs) vs. Incentive Stock Options (ISOs)

Nonqualified stock options differ from qualified stock options, which are more commonly referred to as incentive stock options (ISOs). Here are two main differences:

  • Nonqualified stock options are taxed like ordinary income. NSOs are subject to ordinary income tax, as well as FICA and Medicare taxes. ISOs potentially qualify to be taxed at capital gains rate if the options holder meets certain qualifications.
  • Nonqualified stock options are issued to contracts or consultants, essentially workers that are not considered employees. ISOs are different can only be issued to employees.

Here is an article about incentive stock options.

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Nonqualified Stock Options vs. Restricted Stock Unites (RSUs)

Restricted Stock Units (RSUs) differ from stock options generally and are used

  • RSUs are not an option. RSUs have a structure where employees receive shares after a certain amount of time spent at their employer. NSOs are options, so the employee will still need to purchase the shares in the future at the exercise price.
  • RSUs are taxed when they are vested at regular income. NSOs are taxed when exercised.

Here is an article that goes into the differences between more employee compensation tools.

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Nonqualified Stock Options Tax

Given the expectation is that value of options will have increased over time, the employee stands to make a profit when they exercise their NSOs which counts as taxable income. One of the big differences between ISOs vs NSOs is that NSOs are taxed the same as ordinary income.

Once you exercise your nonqualified stock options, the difference between the current stock price (price at the time you exercise) vs. the exercise price, or strike price, becomes your profit. This will become your tax liability.

Below is a simple equation for this math:

Tax Liability = Number of Exercised Shares * (Market Value of Shares at Exercise – Strike Price)

For example:

  • If you exercise 1,000 shares at a strike price of $50
  • The fair market value of the shares at the time of exercise is $75
  • You pay $50,000 to exercise your options (Number of Share * Strike Price)
  • In return, you receive $75,000 worth of shares (Number of Shares * Fair Market Value of Share at Exercise)
  • Your tax liability is $25,000 ($75,000 - $50,000 = $25,000)

In the above example, the $25,000 profit the employee made will be taxed at the ordinary income and is usually reported on your paystub. There are is no tax liability when you receive your options.

Here are some tax lawyers to consult.

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Are NSOs subject to FICA?

Generally, there is no tax on the issuance of options. Once the options are exercised, the option holder will pay ordinary income tax and is subject to FICA and Medicare, and tax withholding is required for employees.

Here is an article about FICA tax.

Most Important Terms In Nonqualified Stock Options

Given the issuance of options to employees are done through legal agreements, it is important to understand the key terms of your options contract. Below are some of the most important terms to keep in mind:

  • Exercise (Strike) Price. The exercise price, or strike price, is the price at which the company offers the employee shares in the future. In other words, a company may offer a strike price of $20 per share. This means the company believes the shares are valued at $20 per share at the current time of issuance.
  • Vesting Date. The vesting date is typically the first day an employee is allowed to exercise their options.
  • Vesting Schedule. The vesting schedule is the timeframe set up by the employer that an employee needs to stay to earn the right to purchase the shares in the future. Often, you will see a ‘one year cliff’, which means the employee will need to stay a minimum of one year for any shares to ‘vest’.
  • Fair Market Value. The fair market value of the stock is typically done through a 409A valuation, which gives a fair market valuation of their shares. The exercise price is typically set off some fair market valuation of the stocks.
  • Expiration Date. The expiration date is the time at which an employee can no longer purchase the shares of the company.
  • Exercise Method. The exercise method is the way in which the employee will pay for the future shares. This can be done through cash, stock swaps, and other methods. The specific exercise method may vary depending on the terms of the NSO agreement.

Here is an article about to help you better understand vesting.

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