NON-QUALIFIED STOCK OPTIONS (NQSOs)
NQSOs are comparable to ISOs in a way that they give the option holder the right to buy shares of the company’s stock at a predetermined exercise strike price. Rights normally have a 10-year window in which they must be exercised or they will expire, and they may be subject to vesting restrictions as well.
The key distinction is that when they are exercised, compensation income is generated that is subject to ordinary income tax rates that can reach as high as 37%, in addition to FICA and FUTA taxes (FICA, or the Federal Insurance Contributions Act, funds Social Security and Medicare; FUTA, or the Federal Unemployment Tax Act, funds unemployment benefits). The difference between the FMV at the date of exercise and the exercise strike price is the amount of taxable income. The holding period of the stock therefore starts on the day following the exercise date, and the stock received then assumes a basis equal to the FMV at that time.
Here is how incentive stock options and nonqualified stock options differ in terms of tax treatment. If your company provides you nonqualified stock options, you receive a form of equity compensation akin to incentive stock options or ISOs. With NSOs, you can be subject to two taxes, in contrast to ISOs. You may maximize the value of your stock options by keeping the tax repercussions top of mind.
What are NQSOs?
Employee stock options and exchange-traded options are the two forms of stock options available. Here, our attention is on the latter.
Employee stock options provide you the ability, if you so choose, to buy a predetermined number of business shares at a predetermined price for a predetermined amount of time. Stock options could enable you to purchase shares at a cheaper price than what is available on the stock market and profit from that difference if your company’s shares increase in value.
Additionally, there are two separate kinds of employee stock options, each of which has numerous names:
ISOs, or incentive stock options: These are referred to as qualified or statutory stock options at times.
NSOs, or nonqualified stock options: Occasionally known as nonstatutory stock options.
Whatever name you give them, they differ primarily in two ways.
First, NSOs may be issued to consultants, board members, and other outside service providers in addition to workers. Only workers are permitted to receive ISOs.
Second, NSOs are often taxed both upon exercise and again upon the sale of company stock. You can pay more in taxes when dealing with NSOs because they aren’t given the same advantageous tax treatment as their ISO counterparts. For more information, see below.
Your stock options gain value in proportion to the increase in the share price of your company. This describes how employee stock options, a kind of deferred pay, are utilized to encourage and keep employees. The favorable tax status of ISOs makes them appealing, but businesses are only permitted to award each employee with a maximum of $100,000 worth of ISOs annually. Such a cap is not applicable to NSOs, which may be issued in addition to ISOs as an additional benefit.
How Do NQSOs Work?
With employee stock options, your employer grants you a stock option contract on the grant date. The number of shares you have the option to purchase at a certain price (referred to as the strike or exercise price) following the vesting term is specified in this contract. The vesting period is the length of time you must wait and continue working for the company before becoming the true owner of your options. After your options have vested, you have the right to “exercise” them at any moment up to the expiration date in order to buy company shares.
The timing of exercising your stock options depends on a variety of circumstances. The tax ramifications of NSOs will probably play a role in your decision-making when you analyze your financial status and make plans.
Taxation on NQSOs
As was already indicated, NSOs often pay more in taxes than ISOs because they are taxed twice: once upon option exercise and once upon the sale of business shares, as well as because income tax rates are typically higher than long-term capital gains tax rates.
Income Tax Upon Exercise
The “bargain element” is the price differential between the market price of the shares and your NSO strike price when you execute NSOs and choose to buy business shares. You must pay regular income tax on the deal component because it is taxed as compensation.
You’ll be liable for Medicare and Social Security taxes in addition to paying federal and state income taxes. The majority of the time, your employer will assist with tax withholding and may give you the option of paying taxes in cash or limiting the amount of business shares you receive in order to pay the taxes owed.
Capital Gains Tax Upon Sale of Stock
Any gains accumulated following the sale of Company Shares will be subject to capital gains tax in addition to paying income taxes upon exercise. You will be liable for either short- or long-term capital gains taxes, depending on how long you keep your firm shares after exercising your option.
When possible, hold onto your shares for more than a year to be eligible for long-term capital gains rates since long-term capital gains are taxed at a lower rate than short-term capital gains. Since you already have to pay income taxes, doing this can help you pay less overall in taxes.
When planning how to use your NSOs benefits from considering the tax implications, you should make sure you’re considering all the factors pertinent to your particular financial situation by getting a second opinion from a financial or tax professional.
Tax Planning Strategies for Non-Qualified Stock Options (NQSOs)
Timing Considerations for Sale of Shares
Several variables, including work status and the nature of the firm, affect the ideal moment to sell your shares.
The most tax-efficient and feasible course of action for NQSO of publicly traded firms is typically to carry out a same-day-sale or cashless exercise due to the considerable cash layout required by the employee. The employee leaves with cash less any statutory withholdings from the sale of the shares. There are more tax planning options available for non-employee option holders, which we shall go into more depth about later.
The risk of exercising and holding NQSOs, even at the expense of paying the necessary tax withholdings and strike price out of pocket, may be worthwhile to take into account for privately held NQSO shares where the current spread may be significantly less than the expected future value of the shares.
In all cases, it’s important to understand individual withholding shortfalls and estimated tax obligations, to know how an increase in income from the exercise and sale will affect your tax bracket relative to tax years past, and to keep an eye out for the remaining options’ impending expiration dates.
Estimated Tax Obligations
The projected tax obligations for individual taxpayers and the statutory withholding percentages for supplemental wage payments, such as income from stock option exercises, must be understood by non-qualified stock option holders.
On the gain component of an exercise of non-qualified stock options, employers are required to withhold income taxes, social security and medicare taxes (social security up to the maximum pay cap in place for the year). These supplemental wage payments must have withholdings made according to the tax code at the statutory rates, which are currently 22 percent for federal income taxes and 10.23 percent for state income taxes in California. Other flat withholding rates might be necessary in other states. The first $1 million in supplementary wage payments made for the year are subject to the federal rate of 22%. The statutory rate rises to 37 percent after the $1 million mark is achieved. The maximum regular income tax rates in the United States are now 37 percent and 13.3 percent, respectively. For taxpayers that use NQSOs, this could result in a withholding shortage, which frequently leads to more taxes owing at the time of filing.
Your ability to minimize your tax liability is significantly impacted by the expected payment timing requirements. Taxpayers who fail to comply with the safe harbor standards for either the prior year or the current year are subject to underpayment penalties. The underpayment penalty is effectively interest that the government charges the taxpayer for using the funds during the year, even though the IRS refers to them as penalties and leaves the possibility of abatement open in some cases. On an annualized basis, the current underpayment penalty rates are at record lows of 3%.
According to the prior year safe harbor, in order to avoid underpayment penalties for the current year, a taxpayer must pay in at least 100 percent or 110 percent of their prior year tax bill. Any combination of withholding or anticipated tax payments may be used to make the payments. In order to avoid underpayment penalties, a taxpayer must pay in at least 90% of the expected current year tax during the year, again by any combination of withholding or quarterly tax payments. The majority of taxpayers will find themselves depending on the prior year safe harbor in the event of an income increase brought on by the exercise of non-qualified stock options. There is frequently enough tax paid in based on the exercises so no further payments are necessary during the year because of the obligatory withholdings on exercise.
Taxpayers can improve their tax efficiency in this situation by investing the money that would have been withheld from their monthly paychecks in order to earn a return prior to having to pay taxes to the government, or by eliminating future quarterly tax payments for the remainder of the year. However, extra care must be made to ensure the correct amount of taxes have been paid in to prevent being punished for taxpayers who have sideways or down income years compared to the prior year.
Arbitrage of Marginal Tax Rates
The effect it will have on their anticipated marginal tax rate in comparison to their anticipated tax rate for the subsequent tax year is something non-qualified stock option holders need to be aware of. You should be strategic about generating more revenue or claiming deductions so that you are maximizing tax efficiency using the principles of tax rate arbitrage.
When it is feasible, further income recognition should be postponed until the following year, assuming a marginal tax rate that is equivalent to or lower than the current year’s. Generally speaking, deductions should be made earlier in the year rather than later or the following year. Strategic decision-making in this case may result in long-term tax savings on the rate difference.
There are a few typical tactics that may be used, even though taxpayers may not have complete control over the timing of all income or deduction items.
- Taking PTO or vacation compensation in cash
- Gainful asset sales
- Customers’ invoices are sent to self-employed taxpayers
- Roth reversals
In terms of deduction:
- Mortgage payments made in January of this year were prepaid.
- Contributions to charities
- Business costs for taxpayers who are self-employed
- Losses on the sale of assets or bad debts are recognized
- The release of held-back passive losses on asset sales
Depending on your particular circumstance, you may have access to more tools, but this covers some of the most typical situations.
Stock Price Risk Elements
The final option for employee NQSO holders involves stock price risk. The period of non-qualified options is typically no more than 10 years from the award date. You should study the details of your equity grant agreement.
The window of time in which the taxpayer can exercise and sell the option gets shorter as the non-qualified stock options’ expiration date approaches. As this time period draws near, the taxpayer faces a greater danger that a black swan event, uncontrollable circumstances, or possibly subpar handling of circumstances that are under its control, could significantly lower the stock price. Even if the decline is just temporary, the taxpayer might be obliged to sell these options at a loss if the exercise window is getting smaller.
Planning for a medium-term time horizon that spans several years can guarantee that taxpayers make wise decisions regarding the timing of NQSO exercise and sale transactions, the reduction of pricing risk as execution windows close, and the holding back of equity awards with longer expiration time horizons for future years. While we constantly work to keep our equity award transactions as tax-efficient as possible, paying more tax on greater revenue due to a high sale price is always better to paying less tax on lower income owing to a sale at a considerably lower price.
Holders of Non-Employee Options
Holders of Non-Employee NQSOs have access to more strategic alternatives because any revenue realized is regarded as self-employment income. Directors of companies who get equity awards as payment for their director services frequently experience this.
- Directors may use business costs to offset income, such as
- Office deductions at home (even carried over from prior years where no income was recognized but director services were still being performed)
- The cost of using a cell phone and the internet for communication
- Travel and parking fees
- And possibly most notably, the costs associated with the self-employed business’ retirement plan. Depending on the situation, several retirement plans allow deductions far into the five and even six figures, which can result in large tax savings.