Non-statutory stock options, also called non-qualified stock options, NSOs, or NQOs, are a type of employee stock option that can be offered without restriction. Unlike ISOs, NSOs can be offered to not just employees, but also vendors, contractors, members of the board of directors and anyone else to whom a company decides to issue stock options. Non-qualified stock options are so named, because they do not qualify under the strict definition of ISOs, which is to say that they are much more flexible and have few restrictions on the manner of issuance.
Although NSOs are simpler to issue and require somewhat less regulatory red tape to issue and exercise, they still must comply with SEC guidelines. Therefore, it is still important to consult a corporate securities lawyer before using these stock instruments. The Priori network makes it easy for you to find a vetted lawyer you can trust.
How Non-Qualified Stock Options Work
Non-qualified stock options are the most common type of stock options offered to employees as a benefit. The idea is that you can purchase stock for a fixed price for a defined period of time, as the market value of the stock continues to rise. Hopefully, by the time your stock vests, you can make a profit off the shares.
For NSOs, this profit can conferred right away. NSOs are not restricted by waiting periods. You can sell shares immediately after they vest for an immediate, unlimited profit. There is no minimum price for such stock, so the company can set the exercise price at any level desired. In addition, employees are not limited in the amount of money they can make off the NSOs that are exercised.
NSOs and Tax Considerations
NSOs are considered a type of ordinary income that you receive from your company. You are taxed on the day you exercise the non-statutory stock options on the difference between the grant price and the stock’s fair market value. Generally, this will appear on your W-2, just as any other form of compensation would. For tax purposes, NSOs are initially considered similar to a cash bonus or other wage. When you sell the stocks, you are taxed in the same way as you would be when selling any stock—as short- or long-term capital gains, depending on how long you hold the stock.
Advantages of Non-Statutory Stock Options
There are three major benefits of NSOs for companies and employees:
- Increased employee income without additional employer expense. Employees can substantially increase their income as stock price increases, but this expense is borne by the open market, not the employer.
- Improved employee morale and engagement. Any benefit can raise employee morale, but NSOs are particularly effective, because they offer employees the chance at higher income and a feeling that their actions can impact their earnings.
- Flexibility in terms of tax impact. Because the timing of exercising NSOs is flexible, you can minimize the tax impact by deferring the exercise and sale of options until it is financially prudent. From the company standpoint, there are also tax deductions available for the amount of spread employees report as income.
Disadvantages of NSOs
There are three important disadvantages of NSOs for companies and employees to consider before exercising non-qualified options:
- Larger tax burden. Because NSOs are treated as ordinary income, exercising options is a significant tax event and can even push an employee into a different tax bracket.
- Potential risk. There is no guarantee that stock prices will rise, which means that options can turn out to be useless or a loss, lowering productivity and morale in addition to the financial impact.
- Exercise issues. If cash is required upfront to exercise options, this can exclude many employees from affording the benefit. Even cashless stock exercises can be prejudicial against lower income employees, as they miss out on potential capital gains when they are required to sell exercised shares immediately.
Depending on your needs, the cost of creating a stock option plan can vary significantly. Priori attorneys typically work from approximately $150 per hour up to $450 per hour for this type of work. In order to get a better sense of cost for your particular situation, put in a request to schedule a complimentary consultation and free price quote from one of our lawyers.
What’s the difference between non-qualified stock options and incentive options?
While both types of employee stock options, ISOs and NSOs are taxed differently. ISOs are taxed as capital gains at a generally much lower rate, unlike NSOs which are taxed under the ordinary federal income tax rate. In addition, ISOs are generally more limited than NSOs. ISOs are limited to executives and other key employees and are capped at $100,000 per employee each year.