Nonqualified Stock Options and the Tax Impact of NSOs

Nonqualified stock options face less favorable tax treatment than incentive stock options — here's how they differ.

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If your employer grants you nonqualified stock options, you’re receiving a form of equity compensation similar to incentive stock options, or ISOs. However, unlike with ISOs, you may be taxed twice with NSOs. Keeping the tax consequences top of mind can help you make the most of your stock options.

What are nonqualified stock options?

When it comes to stock options, there are two different types: exchange-traded options and employee stock options. Here, we’re focusing on the latter.

Employee stock options give you the right to purchase a set quantity of company shares at a fixed price during a certain time period, if you choose to do so. If your company shares appreciate, stock options could allow you to purchase shares at a lower price than what’s available on the stock market and benefit from that difference.

There are also two different types of employee stock options, and they each go by many names:

  • Incentive stock options, or ISOs. Sometimes these are called qualified or statutory stock options.

  • Nonqualified stock options, or NSOs. Sometimes called nonstatutory stock options.

However you call them, there are two main differences between them.

First, NSOs can be granted not only to employees but also to outside service providers, such as advisors, board directors or other consultants. ISOs can be issued to employees only.

Second, NSOs generally are taxed upon exercise, then again when company shares are sold. Since they don't receive the preferential tax treatment of their ISO peers, you may face a higher tax burden with NSOs. See below for more detail.

The more your company's share price grows, the more valuable your stock options become. This explains why employee stock options are a type of deferred compensation used to motivate and retain employees. ISOs are attractive due to their preferential tax treatment, but employers are capped at giving no more than $100,000 worth of ISOs to each employee every year. NSOs aren't subject to such a limit and can be granted as an extra benefit on top of ISOs.

» How do stock options differ from RSUs? Learn more about restricted stock units

How nonqualified stock options work

With employee stock options, you’re awarded a stock option contract from your employer on the grant date. This contract details the amount of shares you have the right (but not the obligation) to buy at a fixed price (called the strike or exercise price) after the vesting period. The vesting period refers to the amount of time you need to wait — and stay employed with the company — before gaining actual ownership of your options. After vesting, you’re able to “exercise” your options and purchase company shares at any point in time up until your options’ expiration date.

There are many factors that go into figuring out when to exercise your stock options. As you think through your financial situation and make plans, the tax implications of NSOs will likely factor into your decision-making.

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Taxation on nonqualified stock options

As mentioned above, NSOs are generally subject to higher taxes than ISOs because they are taxed on two separate occasions — upon option exercise and when company shares are sold — and also because income tax rates are generally higher than long-term capital gains tax rates.

Income tax upon exercise

When you exercise NSOs and opt to purchase company shares, the difference between the market price of the shares and your NSO strike price is called the “bargain element.” The bargain element is taxed as compensation, which means you’ll need to pay ordinary income tax on that amount.

In addition to owing federal and state income taxes, you’ll also be responsible for Medicare and Social Security taxes as well. Your employer usually will help facilitate tax withholding and may offer you the choice of paying taxes using cash or reducing the number of company shares received to cover the taxes due.

» Looking to minimize income taxes? Charitable giving can reduce your tax burden

Capital gains tax upon sale of stock

On top of paying income taxes upon exercise, any gains accrued when company shares are sold will be subject to capital gains tax. Depending how long you hold your company shares post-exercise, you will be responsible for either short- or long-term capital gains taxes.

Since long-term capital gains are taxed at a lower rate than short-term capital gains, it may make sense to hold onto your shares for over a year, when possible, so you can qualify for long-term capital gains rates. This can help minimize your overall tax burden since you already have to foot the bill for income taxes.

Paying attention to tax consequences helps when planning what to do with your NSOs. Getting a second option from a financial or tax advisor can help ensure you’re thinking through all of the considerations relevant to your unique financial situation.

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