What Are Non-Qualified Stock Options?

Summary 

Equity compensation has become a standard part of pay packages, especially in the technology sector. Stock options provide employees the chance to acquire ownership stakes and benefit from the growth and success of the company. The two main types are incentive stock options (ISOs) and non-statutory stock options (NSOs). While ISOs have tax advantages, NSOs offer more flexibility. 

NSOs, or non-qualifying stock options, are a form of equity pay that does not qualify for the preferential tax treatment of ISOs. The name non-statutory comes from the fact NSOs do not satisfy Section 422 of the tax code which covers statutory stock options.

NSOs provide the right to purchase company stock at a set price, known as the grant, exercise or strike price, within a defined period. The strike price is typically the fair market value on the grant date. NSOs allow profiting from any increase in stock price above the strike price. This bargain element is taxed as ordinary income. Let us explore how NSOs are taxed next. 

How NSOs Are Taxed

A major difference between NSOs and ISOs is the tax treatment. With NSOs, taxes apply on the spread at exercise - meaning the difference between the strike price and fair market value when the option is exercised. This profit is viewed as a compensation and taxed as ordinary income.

For ISOs, tax is deferred until selling the shares, not at exercise. If ISOs meet holding periods, gains may qualify for preferential long-term capital gains rates. But ISOs have strict limits on eligibility and number of shares.

Recipient Eligibility

While ISOs are solely for employees, NSOs have flexible eligibility. NSOs are often granted to employees and directors. But they also may be offered to advisors, consultants, vendors, and others delivering services. This makes NSOs useful for startups working with contractors.

This broader eligibility is a key advantage of NSOs. They allow providing equity pay not just to formal employees, but also to non-employee contributors vital to the company's success.

Major Advantages of NSOs

For a beneficiary, NSOs offer several compelling benefits. They can:

• Offer an alternative to cash compensation at capital-constrained startups.
• Reward, motivate and retain employees and contributors.
• Allow sharing in the upside growth and risk of the company.
• Act as a valuable recruitment tool if the stock is appreciating.
• Serve as deductible, as a compensation expense for the company.
• Have simpler structure than ISOs with fewer restrictions.
• Remove limit on the number of shares that can be offered.

Potential Limitations

Alongside the many benefits, beneficiaries also need to be aware of some potential limitations of NSOs. They can:

• Lack the preferential capital gains treatment of ISOs if holding periods are met.
• Owe taxes at exercise, unlike ISOs which permit deferral until sale of shares.
• Have the need to comply with Section 409A rules governing nonqualified deferred compensation.
• Hamper recruiting by replacing too much cash pays with stock.

Exercising NSOs

Once vested, NSOs can be exercised at any point before expiration, either while still being employed or after leaving the company. Exercising requires paying the strike price, either in cash or via cashless exercise if permitted.

Taxes are owed on the spread between strike price and market value at exercise. NSO shares can be sold immediately or held. If held under one year before selling, gains are taxed as short-term capital gains. After one-year, long-term capital gains rates apply.

Valuing NSOs:

There are three common methods to value NSOs. They are:

• Black-Scholes: This method is widely used and considers factors like stock price, strike price, expiration date, and volatility.
• Binomial: The Binomial method is quite similar to Black-Scholes but simpler in calculation.
• Monte Carlo: This uses computer simulations to predict future prices of NSOs.

However, the ideal valuation method depends on the NSO's specifics. For instance, Black-Scholes suits NSOs with longer expiration dates, while binomial and Monte Carlo are apt for shorter ones.

Tax Tips for NSOs

If you wish to lessen your NSO tax burdens, consider the following measures:

• Staggered Exercising: Exercise NSOs gradually to distribute the tax liability over years.
• Exercising with Losses: Use NSOs in a year with other financial losses to counterbalance the tax.
• Gifting NSOs: Transfer NSOs to family in lower tax brackets, like a spouse or child.

NSOs in Business

Companies across sectors, from tech and healthcare to finance, deploy NSOs. Both budding startups and mature firms use them. Startups, often limited in offering hefty cash packages, leverage NSOs to draw and keep talent. Meanwhile, larger firms use NSOs for employee rewards and alignment with company objectives.

NSOs can motivate varied roles - from incentivizing sales teams to close deals to spurring engineers for innovation. In essence, while NSOs are beneficial for firms to magnetize and inspire staff, employees must be tax-aware before making NSO choices. 

Summing Up

NSOs are a flexible equity compensation tool with wide eligibility. They help align employee interests with the company by providing ownership opportunities. Although NSOs lack some tax advantages of ISOs, they make up by offering simplicity and fewer restrictions. Overall, NSOs can form an important piece of a well-rounded pay. However, employees benefitting from NSOs need to get a firsthand account of what they are and how they can be leveraged. For more information, consulting a financial advisor is recommended.