Non-qualified stock options (NSOs) are a form of equity compensation typically given to non-employees — but can be given to employees under some circumstances.
NSOs cost money to exercise but their tax treatment is less favorable than incentive stock options (ISOs).
What is an NSO?
Non-qualified stock options (NSOs) are a kind of stock option typically given to non-employees (like consultants or other service providers), however, employees may also receive these under other circumstances. An NSO is an option to buy a share at a fixed strike price.
While NSOs work in a similar way as ISOs — as in you’ll have to vest and pay money to exercise them — they do not carry the same tax advantages. If ISOs are the Teslas of the stock option universe, consider NSOs to be the Prius — still an electric ride, but not quite as luxurious (tax-wise).
Also, remember that most NSO grants are subject to vesting. Until equity — in whatever form it has been granted — has vested, the company can take it back, so it's not really yours yet. "Vesting" means the release of the company's take-back right, and the "vesting schedule" is the schedule according to which that release happens. And most importantly, when your ownership begins!
Remember we said NSOs are the less tax-efficient cousin of ISOs? Here’s why:
Taxes and your NSOs
Upon exercising your NSOs, you will immediately owe tax — regardless of whether you sell the shares later.
Several important things to know about such taxes:
These taxes are charged at ordinary income rates rather than under the AMT system like ISOs.
This taxable amount is calculated on the difference between your strike price and the fair market value (FMV) at the time of exercise. (Ex. Your strike is $2.00 and the FMV is $6.00 — you’d pay income tax on the $4.00 of gain per share.)
Then, selling the shares is another taxable event. If and when you sell your shares down the road, the timing of when you exercised those NSOs and when you sell them as shares (either on a public or secondary market) will determine whether you pay short-term or long-term capital gains.
The ideal is to only sell when you have qualified for long-term capital gain treatment. To qualify for long-term capital gains, the date you sold those shares must be:
More than one year from the date you exercised your NSOs
Exercising your NSOs
Typically most companies only offer 90 days to exercise your vested NSOs from the last day at the company.
Make sure to consider the amount of tax you will owe upon exercise on top of the exercise cost itself when saving up to exercise your NSOs or make a plan to use option funding.
A basic formula you can use to calculate your potential earnings from an NSO grant is Your net gain = Total sale proceeds - (Your exercise cost + Ordinary Income Tax + Capital Gains taxes).
This material has been prepared for informational purposes only and is not intended to provide, and should not be relied on for investment, tax, legal, accounting, or other professional advice. Vested does not provide investment, tax, legal, accounting, or other professional advice. You should consult your own investment, tax, legal, accounting, or other professional advisors before engaging in any transaction or equity decision.