Non-Qualified Stock Options

Updated on April 30, 2024
Article byWallstreetmojo Team
Reviewed byDheeraj Vaidya, CFA, FRM

What Are Non-Qualified Stock Options?

A non-qualified stock option is an employee stock option wherein the employee pays ordinary income tax on the difference between the grant price and the fair market price at which he exercises the option.

Non-Qualified Stock Options Definition

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A non-qualified stock option is one way to reward employees. It also gives greater flexibility to recognize the contributions of non-employees. It is a valuable part of an employee compensation package, especially if the company’s stock has been soaring of late. Non-qualified stock options are also very relevant for the employer. The amount of the compensation element is generally deductible as a compensation expense.

How Do Non-Qualified Stock Options Work?

Non-qualified stock options definition states that they are the set of ESOPS in which the employee is required to pay income tax at the ordinary rate of income tax on the difference amount of the grant price and the price at which the employee exercises the option.

The key elements of such options:

Non-Qualified Stock Options

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Examples

Below are some examples of non-qualified stock options:

Example #1

A.B Food is a UK-based company listed on the London Stock Exchange. Assume the share price of the company is $10. It grants an NQSO at a $10 exercise price. The share value is $20 after one year.

Employees have the following options:

  1. Exercise, sell immediately: Immediately sell the stock for $20. They will have $10 per share as income.
  2. Exercise, hold for more than a year, sell: If they sell it for $25, the bargain element is $10 (fair value- exercise price) and is taxable when exercised. They will have a $5 long-term capital gain (S.P of $25-Value at exercise date $20).
  3. Exercise, hold for less than 12 months, then sell: Here, $5 gain becomes a short-term capital gain.
  4. Employees can exercise an option even if the value is less than the exercise price. Usually, it happens when there is a chance to increase value in the future, but the expiration date is nearing.

Example #2

Mr. Bill is an employee of a US-based company named Marvell Technology Group Ltd. He receives options on a stock that is actively traded on NASDAQ.

He purchased 1,000 shares of company stock and was granted the option to purchase stock. It’s taxable only when he exercises those options and later sells the stock he purchased.

Tax Implications

Here are  the  four scenarios based on Example – 2 above to depict the non-qualified stock options tax treatment more clearly:

1. Exercises then hold

The exercise date is 30th June 2017. Bill exercised the option for $20. The current price is $40. It has not yet sold. There are 100 shares in total.

The compensation element can be calculated as:

Difference between the Exercise Price and Current price multiplied by several sharesNumber Of SharesShares Issued refers to the number of shares distributed by a company to its shareholders, who range from the general public and insiders to institutional investors. They are recorded as owner's equity on the Company's balance sheet.read more bought.

$(40 – 20) = $(20 x 100)= $2,000.

Now, the employer will include this compensation element amount ($2,000). Therefore, Mr. Bill will be taxed on the compensation element.

2. Exercises and sells the shares on the same day

The exercise date and sales day are the same as 30th June 2017. The exercise price is $20. The current market price is $40 and the sales price. And $10 is a commission paid for salesCommission Paid For SalesSales commission is a monetary reward awarded by companies to the sales reps who have managed to achieve their sales target. It is an incentive geared towards producing more sales and rewarding the performers while simultaneously recognizing their efforts. A sales commission agreement is signed to agree on the terms and conditions set for eligibility to earn a commission.read more. There are 100 shares in total.

The compensation element will be the same as $2,000, and the employer will include $2,000 in income.

He sold the stock right after he bought it; the sale counts as short-term, and $10 is a short-term capital lossCapital LossCapital Loss is a loss when the value of the consideration received from the result of the transfer of capital assets is less than the aggregate value of the cost of acquisition & cost of the improvement. In simpler words, it can be stated as the loss derived from the transfer of capital assets.read more.

He sold the stock for $4,490 that he purchased for only $2,500.

3 – Exercises and sells them within a year

The exercise date is 30th June 2017. The exercise price is $20.

The current market price is $40. He sells the shares before 30th June 2018 at $50 and $10 is the commission. So there are 100 shares in total.

The bargain element of $2,000 is taxable income. The stock sale, here, is a short-term transaction deal because he owned the stock for less than a year. The short-term capital gain is the difference, i.e., $490.

4. Exercises then sell them after more than a year

In the examples above, if the shares are sold post one year. Again, the gain will be long-term capital gain.

The bargain element is $2,000. The stock sale gain is $490. So he has to pay a marginal tax on the capital gain.

Advantages

Disadvantages

  • If cash compensation is removed, insufficient cash salaries may be an obstacle to recruiting suitable employees.
  • It does not give special tax treatment to employees like ISO.

Non-Qualified Stock Options Vs Incentive Stock Options

BasisIncentive Stock OptionsNon-Qualified Stock Options
AvailabilityOnly available for employees;It is available for employees, consultants, and advisors.
Tax TreatmentQualifies for special tax treatment;The compensation element is treated as an ordinary incomeAn Ordinary IncomeOrdinary income refers to an individual's or business entity's earnings that are taxable at the regular rates. Such earnings include salary, wages, rent received, royalty, commission, interest received, profit, etc. It excludes all incomes with tax deducted at source and capital gain.read more in the hands of the employee.
Benefit for employeeUsually seen as more advantageous for the employee;It is not advantageous to the employee as it is taxable based on a certain condition.
Benefit for EmployerThe employer does not prefer it.Employers prefer it because the issuer is allowed to take a tax deduction equal to the amount the recipient is required to include in his or her income.

This article is a guide to what are Non-Qualified Stock Options. Here we explain vs incentive tax options, examples, and tax implications. You may learn more about accounting from the following articles –

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