Non-Qualifying Stock Options – Equity Compensation at Private Firms

Next in our Equity blog series we will take a look at Non-Qualifying Stock Options (NSOs).

Don’t let the name “non-qualifying” confuse you. “Non-qualifying” simply means that this type of stock option does not qualify for special treatment the same way incentive stock options are treated. You can also think about “non-qualifying” stock options as “regular” stock options.

Let’s look at an example

Let’s say Jill joins XYZ Company in June 2018 and is given a non-qualifying stock option for 1,000 shares at a grant/exercise/strike price of $5. For simplicity sake, we’ll say that shares will vest at 25% per year:

• June 2018: Stock option granted
• June 2019: 250 shares vested
• June 2020: 250 shares vested
• June 2021: 250 shares vested
• June 2022: 250 shares vested

In June 2022, all 1,000 shares of XYZ Company’s stock have vested. Jill decides to exercise her option to buy all 1,000 shares at her grant price of $5 per share when the value of XYZ Company’s stock is $50 per share.

Jill writes her company a check for $5,000 (1,000 shares x $5 per share), and the company in returns gives Jill 1,000 shares of stock. Jill is now officially a stockholder.

How NSOs are taxed: Jill paid $5 per share for a stock that is valued at $50 per share. This $45 difference is considered income to Jill and is included on her Form W-2:

1,000 shares x $45 difference between grant price ($5) and fair market value ($50) = $45,000 included on Jill’s Form W-2

Sale of NSO Stock: If the stock is held for one year or longer past the exercise date, long-term capital gains tax rates apply. Otherwise any gain is considered ordinary income.

Talk to your employees

There is of course a tax on this “paper” income. It’s important that you inform your employees to prepare for this additional tax, so they are not caught off guard when the taxman comes calling.

Next: Incentive Stock Options

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