Non-Qualified Stock Options (NQSOs) 101

Here we come to the end of our Employee Stock Options series – after introducing Incentive Stock Options (ISOs) and the general idea of Employee Stock Options – Today’s focus is on Non-Qualified Stock Options (NQSOs).

NQSOs have many similarities with ISOs, especially on how you receive the plan and how the plan is distributed. You can review it in our article about ISOs to get familiar with the process. The main difference lies within the taxation and the audience the plan faces.

Audience

For example, ISOs can only be awarded to employees and only up to certain limits. They have the advantage of?potentially preferential tax treatment?if you meet certain holding period requirements. On the other hand, NQSOs have the unique advantage of being able to be awarded to both employees and non-employees. This allows a company to compensate directors, contractors, suppliers, consultants, lawyers, and others for services rendered or as recognition for their dedication to the company.

Tax

Both plans are not taxed when you are granted and vested but are taxed differently when you are exercised and liquidated. A table below demonstrates the difference directly.

From the table, it shows if you have NQSOs, the bargain element is typically taxed as ordinary income to the shareholder, subject to Social Security and Medicare taxes, like your regular wage income.?This means that taxable element shows up I boxes 1, 3, and 5 of a year-end W-2. If you have ISOs, the bargain element may be taxed several ways depending on the timing of when you exercise your option and when you sell your shares. You may also need to address the?Alternative Minimum Tax (AMT) under ISOs.

You will owe tax when you exercise your NQSOs and might get a big tax bill. Using a simple example to illustrate:

• Exercise price: $5
• Stock fair market value: $55
• Number of Shares Exercised: 10,000

Taxable amount = Shares Exercised 10,000 * (FMV $35– Exercise price$5) =$300,000 If we assume a flat tax rate of 35%, your tax bill would be $105,000.

Options to pay the tax bill at exercise

Many of us do not have $105,000 cash sitting in our banks. Thankfully, there are several other options that can help alleviate the tax pain. The best answer to this question is a customized financial plan and detailed liquidation strategies that can help determine what the best is for you as each individual’s NQSOs are very different. After all, we sincerely hope you have learned many from the series, and thank you for reading the articles.?