Examples of NSOs
For example, you as an employee might receive stock options that have an exercise price of $10 per share. If you had the option to purchase 100 shares, you could pay $1,000 to exercise those options at $10 per share. If the stock price rose to $20 per share, you could exercise the options for $1,000, then sell the 100 shares for $20 per share, or $2,000. You’d make $1,000 in profit. You could also hold the shares and hope that the stock price rises even more, which would make the stock options more profitable.
Paying Taxes on Non-Qualified Stock Options
NSOs do have some unique tax characteristics. Generally, you have to pay ordinary income taxes on the difference between the cost to exercise the options and the value of the options at the time you exercise them, even if you don’t sell the shares right away. So, as in the example above, it would be as if you earned an extra $1,000 in income and have to pay income taxes on that. Then, you would pay capital gains taxes if you held onto the shares after exercising and ended up selling for additional gain. For example, after exercising at $20 per share, suppose the stock rose to $30 per share. If you sold your 100 shares at that price, you would pay capital gains taxes on the additional $1,000 in earnings. Capital gains taxes are dependent on how long you hold the shares.
Other Considerations for Non-Qualified Stock Options
NSOs work by a company giving employees or other stakeholders options to buy company shares as part of a compensation package. The shares have a specific exercise price. Companies then typically have a vesting period, where NSO recipients earn the right to exercise a higher percentage of their NSOs the longer they’re with the company. For example, after two years, you might vest 50% of your NSOs, meaning you can only cash in on half of the options. You’d vest 100% after four years. After vesting, you can decide when to exercise, based on whether the company’s stock price rises above the exercise price. From there, the options become regular shares, with which you can do as you please. These types of stock options are fairly common, as they have fewer restrictions than another type of stock option known as an incentive stock option (ISO).
NSOs vs. ISOs
However, ISOs can be more tax-friendly, as all earnings could potentially count as long-term capital gains (depending on holding periods). In contrast, with NSOs, the difference between the exercise price and fair market value at the time of exercising can be taxed as ordinary income.
