What Are Nonstatutory Stock Options?
Demystify Nonstatutory Stock Options. Explore how these common equity compensation tools function, their tax treatment, and key distinctions.
Nonstatutory stock options (NSOs) are a common form of equity compensation, giving individuals the right to purchase company shares at a predetermined exercise price within a set timeframe. Companies use NSOs to attract, retain, and incentivize employees, consultants, and board members. Recipients can benefit from future stock appreciation without upfront investment.
How Nonstatutory Stock Options Work
NSOs are granted to an individual, providing the right to purchase shares without immediate ownership. The option agreement specifies the number of shares, the exercise price, and the expiration date.
After the grant, NSOs typically follow a vesting schedule. Vesting is when the recipient earns the right to exercise options over time, often tied to continued service or performance. For example, options might vest incrementally over several years, meaning a portion becomes exercisable each year.
Once vested, individuals can exercise NSOs by purchasing company shares at the predetermined exercise price. This action results in actual ownership of the company stock. The decision to exercise is often influenced by the stock’s current market value compared to the exercise price.
After exercise, the individual owns the company stock. These shares can be held for future appreciation or sold immediately, based on financial goals and market conditions. The sale of these shares is the final stage, potentially resulting in a capital gain or loss.
Taxation of Nonstatutory Stock Options
NSO tax treatment is a key consideration, with tax events occurring at different stages. No federal income tax is due when an NSO is granted, as it only provides the right to purchase shares later. Vesting also does not trigger a taxable event, as it does not involve immediate income or property receipt. The tax implications become relevant at exercise.
The primary taxable event occurs upon exercise. The difference between the stock’s fair market value on the exercise date and the exercise price is taxable income. This “bargain element” is taxed as ordinary income, like wages. For employees, this income is reported on Form W-2, Box 1 (often Box 12, Code V), and is subject to federal income tax withholding, Social Security, and Medicare taxes.
After exercising NSOs, any gain or loss from selling the acquired shares is treated as a capital gain or loss. The cost basis for these shares includes the exercise price paid plus the ordinary income recognized at exercise. If shares are held for one year or less after exercise, profit is a short-term capital gain, taxed at ordinary income rates. If held for more than one year, profit is a long-term capital gain, qualifying for lower rates. The sale of these shares is reported on Form 1099-B, and the transaction is detailed on Schedule D of Form 1040.
Key Differences from Incentive Stock Options
Understanding NSOs is aided by contrasting them with Incentive Stock Options (ISOs), which follow different rules. A primary distinction is tax treatment at exercise. NSOs’ bargain element is taxed as ordinary income upon exercise, with withholding. ISOs generally do not trigger regular income tax at exercise, though the bargain element may be subject to the Alternative Minimum Tax (AMT). This difference means NSO holders face an immediate tax liability upon exercise, while ISO holders may defer taxes until the shares are sold.
Tax treatment upon share sale also differs. For NSOs, the cost basis is adjusted upward by the ordinary income recognized at exercise, affecting capital gain/loss calculations. For ISOs, if holding period requirements are met (two years from grant, one year from exercise), the entire gain is taxed at long-term capital gains rates. If ISO holding periods are not met, a “disqualifying disposition” occurs, and a portion of the gain may be taxed as ordinary income, similar to NSOs.
IRS qualification rules further distinguish the two option types. ISOs must meet strict requirements in Internal Revenue Code Section 422. These include being granted only to employees and adhering to limits on exercisable options, such as a $100,000 limit based on fair market value at grant. If an option fails to meet these ISO requirements, it is automatically treated as an NSO. NSOs are not subject to these specific IRS qualification rules, offering companies greater flexibility. This flexibility allows NSOs to be granted to a wider range of individuals, including non-employees like consultants and directors, and without the same limitations on annual value.