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An Introduction to Nonqualified Stock Options

Presented by Will Berigan

A nonqualified stock option (NQSO) is a type of employee stock option used in equity-based
compensation strategies. One of the most common forms of stock options, NQSOs may be granted to
company employees, officers, directors, and consultants. Unlike incentive stock options (ISOs), NQSOs
do not qualify for special favorable tax treatment under the Internal Revenue Code, and there is no limit
on the dollar amount or number of shares an employee may receive. Typically, NQSOs are granted to
employees each year that they participate in the plan, but they can also be granted on a onetime basis.

The option price (also known as the exercise price) is determined by the value of the company’s stock on
the day the option is granted. For example, if the market price of the stock (or, if there is no market price,
the share price determined by formula or appraisal) is $10 on the day the option is granted, then the
exercise price for each option would also be $10, no matter when the option is exercised or how the
market value of the stock changes over time. Most plans give employees a 10-year window to exercise
an option after it has been granted. Some plans may have a vesting schedule, meaning that employees
must wait a set period to exercise their options. Upon separation from service, employees are usually
subject to an accelerated time frame in which to exercise their vested options. Typically, employees have
three months after termination to exercise their options, but, in some cases, they may have to exercise all
vested options prior to their last day of employment.

How Are NQSOs Taxed?

Employees do not recognize taxable income upon the grant of an NQSO. When you decide to exercise
an NQSO, you pay the exercise price per option and acquire the underlying share of the company’s
stock. At that time, you will recognize ordinary income equal to the difference between the exercise price
and the market price of the stock on the date of exercise. This difference is referred to as the spread. The
spread at exercise of an NQSO will be reported on your W-2 and is considered wages for social security
tax purposes.

When you exercise an NQSO, your company receives a corresponding tax deduction equal to the amount
that you have recognized as income. When you sell the shares, whether immediately after exercise in a
same-day sale or following a holding period, the proceeds are taxed under regular holding period rules for
capital gains and losses. The sale of stock must be reported on your annual tax return (Schedule D of
Form 1040).

Examples
Scenario 1: Exercise NQSO and sell immediately

• Option price: $10
• Fair market value on date of exercise: $30
• Sale price: $30

Tax result
At exercise

• Compensation to employee reported on W-2: $20 ($30 – $10)
• Tax basis: $30 ($10 exercise price, plus $20 of compensation)

At sale

• Capital gain: $0
• Shares were sold immediately after exercise, so there is no gain above the basis.

Scenario 2: Exercise NQSO and sell after holding stock for one year

• Option price: $10
• Fair market value on date of exercise: $30
• Sale price: $50
 

Tax result
At exercise

• Compensation to employee reported on W-2: $20 ($30 – $10)
• Tax basis: $30 ($10 exercise price, plus $20 of compensation)

At sale

• Long-term capital gain: $20 ($50 – $30)

This material has been provided for general informational purposes only and does not constitute either tax or legal advice. Although we go to great lengths to make sure our information is accurate and useful, we recommend you consult a tax preparer, professional
tax advisor, or lawyer.

 

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