Explained: How Do Non-Qualified Stock Options Work



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About the Author:
Woman excited about her Stock Option Agreement, but wondering how her Non-Qualified Stock Options work.

Exciting times! You finally landed your dream job, and on top of that, your employer even offers some Non-Qualifying Stock Options! Now, take some time to celebrate before I continue to explain the ins and outs of what that means because the world of stock options can very quickly become complex. Non-Qualified Stock Options are a widely used benefit and part of job offers in the biotech and technology sector. You might want to know how Non-Qualified Stock Options work if they are part of your contract.

In. this post, we will shed some light on what exactly those stock options do not qualify for, what vesting and exercising means, and what you can expect. There are many pitfalls if you don’t know about them. Avoiding them can save you a lot of money and possibly make a lot, too.

Let’s make sure your Non-Qualifying Stock Options provide the value for you they are intended to provide.

What is a Non-Qualifying Stock Option?

Before we look into what a Non-Qualifying Stock Option (NSO) is, let’s look at its counterpart: Incentive Stock Options or ISO. This type of stock option provides an incentive to the owner in the form of a preferred tax treatment or tax benefit. For you, that means you’ll have to pay less taxes if you fulfill all existing requirements. Those requirements are all around when you sell the stocks. If your sale is at least 2 years after the options were granted (the grant date) and one year after you exercised them (the exercise date), your capital gains will be taxed as long-term capital gains. In the US, long-term capital gains get a preferred and lower tax rate than your ordinary income.

Now, let’s take a look at how Non-Qualified Stock Options work. The first part to understand is the word Stock Option. A Stock Option allows you to buy real stocks of the company for a pre-determined and fixed price. You are not required to do so by any means. But you are provided the optionality. Sometimes, the price you get is lower than the fair market value (FMV) of the stock if the company is already publicly traded. For private companies, that is mostly not the case. The fair market value of a private company can stay the same for a long period until a re-evaluation happens.

What does a Stock Option Vesting Plan mean?

When your job offer contains a Stock Option Agreement, part of that agreement is your vesting schedule. This is a multi-year vesting period that defines when your granted stock options are accessible or exercisable for you. You will mostly not immediately be able to exercise your stock options.
A widely used variant of a vesting schedule is the 4-year vesting schedule with a 1-year cliff. In such a schedule, 25% of the granted stock options will unlock for you after 1 year. Then, the remaining 75% of granted stock options is divided into 36 equal portions. Every month after the 1-year cliff will vest 1/36th of the remaining stock options until 100% of the granted stock options have vested after exactly 4 years.

Chart showing a 4-year vesting schedule
Source: esofund.com

How do you Exercise Stock options in a Private Company?

The way you exercise your vested stock options in a private company can be different depending on which system they are using. Traditionally, you would reach out to the financial department with your request. They will send you documents that tell you the current fair market value of the stock. Suppose you are ready to make the purchase. In that case, your company will prepare a document called “Form 3921, Exercise of an Incentive Stock Option Under Section 422(b).” After all parties have signed all documents, you will send a check for the money you must pay to exercise your shares. At the very end, you will get a certificate of stock ownership.

Some companies are now using a service provider like Carta. With a service like this, you can have an account and always see your stock options. In their app, you can exercise your stock options much quicker.

Is there a limit on how many Non-Qualified Stock Options you can Exercise?

There is no annual limit to how many non-qualified stock options you can exercise. You will just have to pay the required short-term capital gains taxes. Depending on your state, there might also be state taxes to pay that apply to your situation.

This stands in contrast to Incentive-Stock Options, as they have a limit of $100,00 annually.

Do Non-Qualified Stock options have an Expiration Date?

Yes! Most commonly, they expire after 10 years. This means that you will want to exercise them before if you want to have ownership in the company. You can always check your Stock Option Agreement to see which expiration date your stock options have.

What are the Tax Consequences of Exercising Non-Qualified Stock Options?

ActionTax Implication
Exercise NSOsPay ordinary income tax on bargain element (if any)
Exercise & sell NSOsPay ordinary income tax on bargain element
Sell before 1-year holdingPay short-term capital gains tax on profit
Sell after 1-year holdingPay long-term capital gains tax on profit

There are many different situations you can find yourself in when exercising Nonqualified Stock Options. From no taxes at all to a huge tax bill over $1,000,000, everything is possible. All of it depends on what the stock is currently worth or what the fair market value of the stock is presently. If the difference between that value and your agreed strike price/purchase price (the spread) is large, your taxes will be higher. You will pay taxes on the difference between the exercise price and the fair market value. You call this difference the bargain element. For Non-Qualifying Stock Options, you will always pay short-term capital gains taxes when you exercise your stock options. This is precisely what is meant by Non-Qualifying. Your immediate gain does not qualify for the lower long-term capital gains tax rate.

Chart showing Non-Qualified Stock Option taxation at sale.
Source: carta.com

There is, however, one possibility of how you can pay long-term capital gains. Not on your immediate gains at the exercise but when you sell your stocks. If you sell at least one year after you exercised your stock options, you will pay long-term capital gains taxes on your gain. To calculate this gain, simply subtract the sale price from the fair market value at the time of the exercise.

To illustrate the complexity, I would like to show you some examples. These will help you understand the different situations more clearly and understand in detail how Non-Qualified Stock Options work. You will be able to determine your own situation and your tax consequences.

Example #1: Exercise Early

Erika works at a private tech startup, and things are going well. The startup got a first financing round, and as part of her job offer, she got an employee stock option plan for 100,000 stock options at a strike price (or grant price) of $0.23. Erika really believes in the company and exercises all her stock options from her option grant when they are vested. In total, she invested $23,000 over 4 years. Since the company is still private after 4 years and no additional capital was raised, the strike price remained unchanged at $0.23. She didn’t have to pay taxes as there was no capital gain at the time of exercise.

The company eventually went IPO 5 years later and became a public company now valued at $43.51 per stock in the open market. Erika still owns all her stocks, now worth $4,351,000. When she sells any stocks, she will have to pay long-term capital gains taxes on the spread between $0.23 and the price of one stock at that time.

Example #2: Exercise Late

Paul started around the same time as Erika, and he also got the same employee stock options agreement. He didn’t exercise stocks until right before the company’s IPO because he didn’t want to lose money. The company was valued at $65 per stock before the IPO, and he now felt comfortable exercising his NSO stocks. His spread is now $65 – $0.23 = $64.77, so he must pay short-term capital gains taxes on a capital gain or taxable income of $6,477,000. Since he does not have enough money, he must immediately sell enough stocks to cover the taxes he now owes.

Conclusions

Both scenarios are very common examples showing how Non-Qualified Stock Options work. It is sometimes hard to wrap your head around the large numbers that can come with stock options. Although Erika’s scenario seems more favorable, she did take a huge initial risk. She could not have known beforehand if and when the company would IPO. In the worst case, the company may never be public, and she would have a complete capital loss.

If your situation allows it, I would always recommend a holding period that allows you to benefit from long-term capital gains taxes on your tax return. This lower tax rate will save a lot of money, but it isn’t always possible due to the many different situations that exist.

If the stocks were ISO stocks (also known as Statutory Stock Options), you would have different tax implications. ISO stocks might be subject to Alternative Minimum Tax. This is even more complex to deal with. I have created a comprehensive overview of ISO vs. NSO vs. RSU Stocks you might be interested in. This post talks about tax consequences from a broader view and shows the key differences between these types of stock options.

You should talk to a financial advisor and tax professional about your specific situation, your stock options, and the best strategy to pursue. Finding a good financial advisor is not easy. I recommend the Garrett Planning Network, the National Association of Personal Financial Advisors (NAPFA), and the XY Planning Network. These networks can get you in contact with a fee-only advisor. No matter how much money you are dealing with, it will not change your costs.

What is a Cashless Exercise?

When exercising stock options creates a tax burden for you, there is also the option to do a cashless exercise. You immediately sell some of the exercised stocks again to cover your taxes. This option might not be available to everyone in a private company since the company might not allow you to sell your stocks. Private companies are not actively traded. They can offer their employees the opportunity to sell some stocks occasionally. But they are not required to ever do that.

Final Thoughts – How Do Non-Qualified Stock Options Work

There are many types of employee stock options. Non-Qualified Stock Options are somewhat simpler in how they work. But knowing beforehand what you are getting into is crucial nonetheless.

In this blog post, you learned what NSOs are and what is part of your Stock Option Agreement. You also learned the tax implications for exercising and owning shares of company stock.

I hope that the examples I provide highlight the complexity and variety that you can find yourself in. Remember that you don’t have to tackle the complex internal revenue code alone. You can talk to a financial advisor and tax professional about your situation, stock options, and the best strategy. I recommend a fee-only advisor in any case since they are operating under a fiduciary standard.

Disclaimer: The information in this blog post should not be considered tax advice or a replacement. They are solely provided for informational purposes. Please consult with a tax professional for any specific questions on your taxes.

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