What is a Nonqualified Stock Option

The topic today is to break down exactly what is a Nonqualified Stock Option. Warning ahead of time. If you are hoping I am going to talk about Incentive Stock Options, you can jump off now. 95% of stock options are nonqualified and I don’t work with clients who have ISOs. If I tried to explain ISOs I’m sure it would be a mess since I don’t cater to clients there. 

Okay, let’s get right to the topic of nonqualified stock options, which I’ll refer to as NSOs or Options. This will actually be a rather straightforward episode as they are not super complex. The complexity with them gets more into the exercise of NSOs. We’ll touch briefly on that, but save the minutia for another post. 

An NSO is a way for you to directly participate and hopefully benefit from your employer’s success. You know, assuming the price of the stock goes up. And this fact is important because there is no financial risk to you until you exercise the options. As another bonus, there are no taxes with stock options until you exercise them. This is different than if your company provides you a cash bonus.

Before I forget, the reason they are called nonqualified stock options is because there are no special tax rules applied to them. Basically, they do not qualify for any special tax treatment. That’s it. 

An NSO is simply an agreement that provides terms under which you can buy a specific number of shares at a set price during a determined timeframe. The details are included in your employer’s stock plan document and be sure to get a copy of it so you know the rules unique to your employer. And do NOT throw it away! 

When you are granted stock options you have the right to purchase a set number of shares at a specific price during a fixed timeframe. The specific price is referred to as the Exercise Price, Grant Price or Strike Price, and when you decide to purchase the shares you have Exercised your options. 

There are a couple of time periods to mention with NSOs. The first is vesting. I’ve talked plenty about this and it is rather simple. It is the period of time before you can exercise your options.  The more important time period is the overall exercise period. This is usually ten years in length. If you do NOT exercise them within this period you lose your options. The most recent data shows that 11% of in the money options, which means they are above the grant price, are allowed to expire every year. There may be a reason why people let these in the money options expire, but I’ve never heard of a legit one. Odds are it is because the options holder and/or the financial advisor were not paying attention. 

Let’s walk through a quick example here. You have 4,000 shares of NSOs awarded to you and your employer has cliff vesting of 4 years.   These shares have been awarded when the stock price is $20. 

• After 4 years all shares are fully vested.
• After this time, the stock price has increased to $35 a share.
• You now have the ability to exercise these options and buy the 4,000 shares at $20, even though they are worth $35 a share. So, you pay $80,000 for shares that are worth $140,000 on the open market. A profit of $60,000 is not too bad! 

Now to when you exercise your options and how you pay for them. Most employers allow you different ways to pay that $80,000 bill. 

• If you have the cash, they may permit you to just pay the $80,000 bill.
• Others may permit a salary deduction. This is going to be more common if your bill is $800 vs $80,000.
• Finally, and this is what I see most often is a cashless exercise. Here shares are sold immediately when you exercise your options and the proceeds will pay that $80,000 bill and associated taxes. 

I mentioned before about 11% of in-the-money stock options expire and also how there is no risk for you with stock options. In-the-money is when the stock price has increased above the grant price when you were awarded the options. In our example it was a grant price of $20 and the stock was worth $35 when you actually exercised it. So, this was in the money by $15. Now, if the stock price drops below the exercise price you do not have to exercise your options as it would be cheaper to buy the company stock on the open market. For example, your exercise price is $20 and the stock drops below this to $10 and never recovers before the options expire. You have no risk either way. If the stock appreciates you technically do not own the stock until you exercise the options and if the stock drops in value, well, why would you spend more than the stock is worth?   

Earlier I said the name nonqualified stock options simply refers to these options not qualifying for any type of special tax treatment. This makes the tax issue for NSOs pretty simple.  When you exercise nonqualified options you will have to deal with taxes. Sorry. A term to become familiar with is compensation income. This is the difference, or spread, from your exercise price and the actual stock price when you exercise. In our example it is the difference between $20 and $35, or $15. The IRS treats this as ordinary income and you have to pay taxes on it that include Income Tax, Social Security and Medicare. Down the road when you sell the shares any proceeds above or below the $35 price will be taxed at capital gains and losses rates. 

This seems like a good place to stop. Otherwise I will start talking about tips for exercising NSOs, which is a whole other post into itself and will be coming soon. Get ready for me to talk about Black Scholes. No, it is not a Netflix series.

I’m Dan Johnson, CFP®, founder of Forward Thinking Wealth Management. I run a flat-fee financial planning and investment management firm located in beautiful Akron, OH. Although I am in Akron, OH, I work with clients regardless of location. I cater to owners of equity compensation positions who are looking to organize their financial lives, keep more of what they make, and do the things they want in retirement and even now.