Non-Qualified Stock Options: A Quick Guide for Tech Employees

By: AJ Ayers, CFP®

You're not alone if you've ever scratched your head over the equity section of your job offer.

According to a recent study by holloway.com, equity levels for tech professionals in post-Series A startups in Silicon Valley can range from 0.2% for a Manager or Junior Engineer to as high as 10% for a CEO.

But what does this mean in the context of NQOs?

In this article, we'll cover:

Types of Equity Compensation: How NQOs differ from other forms like RSUs and ESPPs

Tax Implications: Why NQOs are subject to ordinary income tax rates

Actionable Strategies: How to navigate vesting schedules, exercise periods, and more

Risks and Rewards: The potential pitfalls and windfalls of NQOs

What are Non-Qualified Stock Options?

Non-qualified stock options (NQOs) are a type of equity compensation often granted to employees as part of their overall compensation package. Unlike incentive stock options, NQOs do not qualify for special Alternative Minimum tax treatment, but they still offer employees the opportunity to benefit from the company's growth by purchasing shares at a *potentially advantageous price.

How Do NQOs Work

As an employee, you must typically wait for your NQOs to vest before exercising the options. Vesting refers to the process where options become available for the employee to buy shares in the company's stock. Companies might have different vesting schedules, but it's common to see options vesting over a period of time (e.g., four years with a one-year cliff).

Once your options are vested, you can decide when to exercise them by purchasing company shares at the exercise price. This price is generally set at the stock's fair market value when the stock options were granted, ensuring you score a sweet deal if (and ONLY IF!) your company's stock value goes up over time. However, you should prepare to pay taxes on the difference between the exercise price and the stock's fair market value at the time of exercise.

Deciding when to exercise your options depends on various factors, such as the stock's current value, your financial situation, and expectations for future stock price growth. There might be a deadline, as some companies set an expiration date, usually seven to ten years. Keep track of your vesting schedule and option expiration dates to maximize potential gains.

What Are the Pros and Cons of NQOs

Here are some pros and cons of NQOs.

Pros of Non-Qualified Stock Options (NQOs):

Financial Opportunity: NQOs are valuable if the stock's value increases. The difference between the NSO strike and market prices can lead to substantial gains when exercised and sold.

Flexibility for Companies: NQOs allow companies to tailor equity compensation plans, making them attractive for employers wanting to reward and retain team members.

Investment in Success: Offering NQOs helps employees feel invested in the company's success, aligning their goals with organizational growth.

Cons of Non-Qualified Stock Options (NQOs):

Tax Liabilities: Employees may face hefty tax bills when exercising NQOs. The spread between the grant and market prices at exercise is considered part of your ordinary taxable income.

Risk of Losing Value: NQOs can become "underwater" if the stock price falls below the option's strike price, essentially losing their value and posing a risk to employees.

Strict Timelines: Employees must closely monitor the vesting schedule and exercise timeline. Options usually expire, meaning there's a specific window to exercise your options, or benefits will be forfeited.

What Makes NQOs Different from Incentive Stock Options (ISOs)

While both non-qualified stock options (NQOs) and incentive stock options (ISOs) offer their own unique set of advantages, understanding the differences is crucial when choosing between ISO and NSO.

First, NQOs are more common than incentive stock options, primarily because they are available to all employees and contractors, regardless of their role or position or time spent working at the firm. On the other hand, ISOs are typically reserved for early employees and can only be granted to full-time, W2 employees. NQOs are more accessible and inclusive, allowing a broader range of employees to benefit from company growth.

Another significant difference lies in the way these stock options are taxed. With NQOs, the spread between the grant and exercise prices is taxable income when exercising the option, regardless of whether the underlying stocks are sold or held by the employee afterwards. ISOs, in contrast, receive more favourable tax treatment, as they are not subject to income tax when exercised. Instead, ISOs are only subject to capital gains tax when the underlying stock is sold, which can lead to significant tax savings for employees. But of course, ISOs are subject to the dreaded Alternative Minimum Tax, so watch out for that.

Furthermore, there are specific holding period requirements when it comes to ISOs. For an employee to qualify for the more favourable tax treatment of an ISO, they must hold the exercised stock for at least one year from the exercise date and two years from the grant date. No holding period exists for NQOs, which offers greater flexibility for employees looking to sell their stocks sooner.

When Can I Exercise NQOs?

Exercising non-qualified stock options (NQOs) can be a significant financial decision. Understanding the right time to exercise these options is vital for optimizing their value within your financial plan.

First and foremost, you should evaluate the vesting schedule of your NQOs. Most companies have a predetermined vesting period during which your options gradually become exercisable. You must ensure that you have met this requirement before exercising your options. We recommend setting up a calendar reminder or tracking system to be aware of your vesting schedule.

Once your options have vested, it's essential to consider their current market value. Exercising NQOs converts them into common stock at a predetermined strike price. It’s best exercise your options when the difference between the current market and strike price is significant. Doing so maximizes the profit you make from exercising those options.

Another factor to consider is the tax implications of exercising your NQOs. When you exercise, the spread between the stock's current market value and your option's strike price is considered taxable income at your ordinary income tax rate. To manage your tax liability efficiently, we advise consulting a tax professional to understand the best timing for exercising your options. Book a call here to learn how we provide our clients with a full exercise and sale plan and can estimate your tax liability.

Beware of exerciseing NQOs at private companies. As we discussed, exercising NQOs is an income tax event so if there’s no opportunity to sell the shares in the short term, employees could be left with a large income tax bill but no way to sell the shares for profit, or even to cover the tax expense. Without a public market or a secondary offering on the horizon, employees should think twice about exercising NQOs.

Lastly, you should evaluate your financial situation, goals, and risk tolerance. Holding your options carries more inherent risk, but has the potential for more significant gains. On the other hand, exercising and selling some or all of your newly acquired shares could provide immediate liquidity and diversify your investments. Both strategies have their advantages and drawbacks – you must assess your priorities before deciding.

How are NQOs Taxed

The tax treatment for NQOs is relatively straightforward. When you exercise an NSO, the difference between the exercise price and the stock's fair market value at the time of exercise is considered ordinary income. This amount is subject to federal and state income tax, social security, and other payroll taxes.

It's important to note that withholding taxes may apply to NQOs upon exercise. Your employer is required to withhold a portion of the taxable income for federal and state taxes, as well as any applicable payroll taxes. These amounts are reported on your tax return as part of your overall income.

When you eventually sell the shares you acquired through the exercise of an NSO, you will face capital gains tax on the difference between the sale price and the fair market value at the time of exercise. The tax rate on these capital gains depends on whether they're classified as short-term or long-term. If you held the shares for more than a year, you would be subject to the lower long-term capital gains tax rate.

One strategy to minimize your tax bill involves timing the exercise and sale of your NQOs accordingly. If you believe the company's stock value will continue to rise, it might be beneficial to exercise the options and hold the shares for at least a year to take advantage of the lower long-term capital gains tax rate.

Should I Exercise My NQOs?

Before deciding to exercise your NQOs, it's essential to understand both the potential benefits and the risks involved. Exercising your NQOs might allow you to sell the stock at a higher price if the company's market value increases, potentially yielding a substantial return on your investment. However, you'll also need to consider the cost basis (i.e., the original value of the asset for tax purposes), which could impact your tax liability.

You'll want to consider the potential long-term capital gains to evaluate the tax implications. When holding the stock for more than one year, any gains from the sale of the shares will be taxed at your long-term capital gain rate, which is generally lower than your ordinary income tax rate. If you exercise your NQOs and sell the shares immediately or within one year, you'll be subject to short-term capital gains tax, which could diminish your overall return.

It's crucial to weigh these potential advantages and drawbacks before exercising your NQOs.

You'll also need to consider your current financial situation, company performance, and long-term investment strategy. As always, discuss your options with a trusted financial professional to ensure you make the best decision for your unique situation.

At BKFi, we pride ourselves on helping sophisticated professionals like you make informed financial decisions. We provide thoughtful, comprehensive, and trustworthy advice tailored to your needs and goals. Whether you have questions about NQOs, home ownership, or optimizing your investments, we're here to guide you every step of the way.

Frequently Asked Questions

What is the difference between AMT and regular taxes regarding non-qualified stock options?

The primary difference between the Alternative Minimum Tax (AMT) and regular taxes in relation to non-qualified stock options (NQOs) lies in how taxable income is calculated when you exercise these options. With regular taxes, you pay tax on the difference between the stock's market price at the time of exercise and the option's strike price. This difference is called the "bargain element" and is considered ordinary income.

However, with AMT, the bargain element is added to your taxable income, potentially putting you in a higher tax bracket. As a result, you might pay more in taxes under the AMT system, even if your overall income hasn't greatly increased. Understanding the tax implications of exercising your NQOs to plan effectively and avoid unnecessary tax burdens is essential.

How does a cashless exercise work for non-qualified stock options?

A cashless exercise allows you to exercise your non-qualified stock options without needing upfront cash to cover the strike price and associated taxes. Instead, you simultaneously sell just enough of your exercised shares to cover these costs and are left with the remaining shares. This strategy is appealing if you don't have or don't want to use your funds to buy and sell shares immediately.

Here's how it works: When you choose to exercise your NQOs through a cashless exercise, we can help you facilitate a sale of some of the newly acquired shares in the open market. The revenue from this sale will cover the strike price, taxes, and transaction fees.

The remaining shares are now yours to hold or sell at your discretion. Remember the tax implications and potential market volatility when deciding whether to hold on to these remaining shares or cash them out.