Definition
A Non-Qualified Stock Option (NSO) refers to an employee stock option that doesn’t meet certain IRS requirements to qualify for a special tax treatment. Unlike incentive stock options, NSOs usually incur income tax on the difference between the market value at the time of exercise and the strike price. It’s regularly used within employee compensation packages in large, publicly traded companies.
Phonetic
Non-Qualified Stock Option (NSO) would phonetically be pronounced as: Non-Qualified: /nɒn-kwɒlɪfaɪd/Stock: /stɒk/Option: /ɒpʃən/NSO: /ɛn ɛs oʊ/
Key Takeaways
- Taxation at Exercise: Unlike incentive stock options, non-qualified stock options are typically taxed at the time they are exercised. The difference between the fair market value of the stock at the time of exercise and the option’s strike price is considered ordinary income and is taxed as such.
- Flexibility of Disbursement: NSOs have fewer restrictions compared to other types of stock options. They can be issued to employees, consultants, advisors, contractors, and outside directors, meaning they are not just limited to employees. This provides greater flexibility in terms of who can receive them.
- No Special Holding Period: While other types of stock options like ISOs have specific holding periods to achieve long-term capital gains treatment, NSOs do not have this stipulation. However, to potentially decrease tax obligations, it might be advantageous to hold on to the shares for more than a year.
Importance
Non-Qualified Stock Option (NSO) is a significant term in business/finance because it represents a type of employee stock option where the individual does not have to meet specific requirements that qualified plans must fulfill, permitting the company to give it to consultants, suppliers, employees, and others. It provides an alternative form of compensation beneficial for attracting, motivating, and retaining talent, particularly in startups and growing companies. Upon exercise, NSOs are typically taxed at ordinary income rates on the difference between the market price of the shares and the grant price, making understanding the taxation rules crucial for the option recipient. The flexible utilization of NSOs makes them an integral part of strategic business decisions and compensation plans.
Explanation
A Non-Qualified Stock Option (NSO) plays a significant role in compensating employees beyond their regular salary as part of their overall benefits and remuneration package. They serve as an effective tool and additional incentive for businesses to attract, reward, and retain their valued employees. NSOs epitomize an opportunity presented by an employer to their employees to purchase shares of the company’s stock at a pre-determined price, referred to as the “strike price.”Apart from being a compelling employee morale booster, NSOs are deployed by companies as a method of deferring their cash expenses. They can enable the employer to delay recognizing a compensation expense until the options are exercised, serving to strengthen the company’s financial performance on paper. Consequently, offering stock options can also align the interests of the employees with those of the shareholders, fostering a team environment focused on company growth and profitability.
Examples
1. Google: In 2018, the technology giant Google, handed out NSOs as an incentive for employees. This kind of reward empowers teams with motivation, but also allows employees to invest in their company’s success. However, the employees would have to pay ordinary income tax on these stock options once they exercise them.2. Airbnb: In 2016, Airbnb had garnered a lot of publicity when it extended the expiration date for its employees’ stock options. The company had NSOs which gave the rights to their employees to purchase company’s stocks at a fixed price within a certain period of time. Given they vest, it’s a way of embedding loyalty within the organization, but income tax would be due on them when exercised.3. Amazon: Amazon has also incorporated Non-Qualified Stock Options into its employees’ compensation plans. This serves as a way to attract and retain top talent; however, when those options are exercised, employees are responsible for paying income tax on the difference between the stock’s current value and the price they paid for the shares.
Frequently Asked Questions(FAQ)
What is Non-Qualified Stock Option (NSO)?
A Non-Qualified Stock Option (NSO) is an employer-issued employee benefit that allows workers to buy company shares at a pre-determined price, typically below market price. It’s a common strategy companies use to incentivize and retain employees.
How does a NSO differ from an ISO (Incentive Stock Option)?
The key difference between NSOs and ISOs lies in their tax treatment. With NSOs, when the options are exercised, the increased value of the stock is considered ordinary income, and you will have to pay taxes according to your individual tax rate. ISOs, however, are eligible for more favorable tax treatment if certain requirements are met.
Who can receive NSOs?
Unlike Incentive Stock Options which are only available to employees, non-qualified stock options can be given to employees, directors, contractors, advisors, and others. This makes NSOs more versatile.
Can NSOs be transferred or sold to others?
Generally, NSOs cannot be transferred or sold. However, the employer who grants the options might allow transfers under certain circumstances, depending on the company policy.
When do NSOs vest?
NSOs may vest over a predetermined period, often a series of years. Vesting schedules are set forth in the Stock Option Agreement and can be customized per company.
How are NSOs taxed?
Non-Qualified Stock Options are considered income in the year they are exercised. The income realized from NSOs is the market value of the stock on exercise less the price paid for the stock (the spread). This is taxed as ordinary income and subject to payroll taxes, and is reported on your Form W-2.
What happens to my NSOs if I leave the company?
Usually, if you leave the company, you have a specific amount of time (like 90 days) to exercise your vested options. But the specific details should be found in your Stock Option agreement.
Can NSOs be given to any type of entity?
Yes, NSOs can be given to C corporations, LLCs, and partnerships. They can also be granted to non-employees, like board members or consultants. The key requirement is that the issuer must be a company.
What happens to my NSOs if the company is sold or undergoes an IPO?
The specific treatment of stock options in these situations can vary and will be defined by terms set forth in the Stock Option Agreement. In some instances, options may be cashed out or exchanged for shares in the acquiring company. It’s essential to refer to your specific agreement for details.
Related Finance Terms
- Exercise Price
- Vesting Schedule
- Grant Date
- Employee Stock Option Plan (ESOP)
- Capital Gains Tax
Sources for More Information
