What Are NQSOs and How Are They Taxed?
Learn how to read your NQSO grant agreement and understand the full tax implications, from the ordinary income reported at exercise to the capital gains at sale.
A Non-Qualified Stock Option, commonly known as an NQSO, is a form of equity compensation granted to employees. It provides the right, but not the requirement, to purchase a specific number of company shares at a predetermined price. This compensation is a way for companies to incentivize employees without a significant upfront cash expense. Unlike other forms of stock options, NQSOs do not meet certain Internal Revenue Service (IRS) requirements for special tax treatment.
If the market price of the stock increases above the fixed purchase price, the options become valuable. Employees can then choose to buy the stock at the lower, fixed price and potentially realize a financial gain.
Key Terms of Your NQSO Grant
Your formal grant agreement is the official document that outlines the specific details of your NQSOs. It contains several standard terms that define your rights and obligations. A central detail is the Grant Date, which is the day your company officially issues the options to you. This date starts the clock on your vesting schedule and the overall term of the options. The Number of Options Granted will also be clearly stated, specifying the total quantity of shares you have the right to purchase.
The Vesting Schedule dictates when you earn the right to exercise your options. Vesting is a required period of service you must complete before you can purchase the underlying shares. A common approach is graded vesting, where you earn the right to a portion of your options incrementally over time. Another method is cliff vesting, where you become 100% vested in all your options on a single future date.
Two other important dates are the Exercise Price and the Expiration Date. The Exercise Price, also called the strike price, is the fixed cost per share you will pay to purchase the stock. This price is set to the stock’s fair market value on the grant date. The Expiration Date is the final deadline by which you must exercise your vested options; if you do not act by this date, the options are forfeited. Most NQSO grants have a term of ten years from the grant date.
The Two-Part Tax Impact of NQSOs
The tax implications of NQSOs occur at two distinct events: when you exercise the options and when you sell the acquired shares. The first taxable event happens the moment you exercise your options to buy shares. The difference between the stock’s Fair Market Value (FMV) on the day of exercise and the lower exercise price you pay is considered compensation income. This spread, often called the “bargain element,” is taxed as ordinary income and is subject to federal and state income tax withholding, as well as Social Security and Medicare (FICA) taxes. Your employer is required to report this compensation on your annual Form W-2.
The second taxable event occurs when you decide to sell the acquired shares. For tax purposes, your cost basis in the shares is the exercise price plus the bargain element that was already taxed as ordinary income upon exercise. This higher basis is important because it reduces your calculated capital gain. The amount of tax you owe on the sale depends on how long you held the shares after exercising them.
If you sell the shares within one year of the exercise date, any profit is considered a short-term capital gain and is taxed at your ordinary income tax rate. If you hold the shares for more than one year after the exercise date, any profit qualifies as a long-term capital gain, which is taxed at a lower rate. Your brokerage firm will report the gross proceeds from the sale to you and the IRS on Form 1099-B.
For example, imagine you exercise 100 options at a strike price of $10 when the stock’s FMV is $50. You recognize a bargain element of $40 per share ($50 FMV – $10 strike price), resulting in $4,000 of ordinary income reported on your W-2. Your cost basis for the 100 shares is now $5,000 ($1,000 exercise cost + $4,000 taxed income). If you sell those shares two years later for $70 each, your long-term capital gain is $20 per share ($70 sale price – $50 basis), for a total gain of $2,000.
How to Exercise Your Options
Once your NQSOs have vested, you must follow a procedure with your employer or the brokerage firm that administers the plan. There are several established methods for completing the exercise, each with different cash flow requirements.
The most direct method is a Cash Exercise. In this transaction, you pay the full cost to purchase the shares using your own funds. This amount is calculated by multiplying the number of shares you are exercising by the fixed exercise price. You must also provide sufficient funds to cover the required tax withholding on the bargain element. After the transaction, you become the owner of all the shares you exercised.
A frequently used alternative is the Sell-to-Cover Exercise. In a sell-to-cover, you instruct the brokerage to immediately sell just enough of the newly acquired shares to pay for the total exercise cost and the tax withholding obligations. You then receive the remaining net number of shares, which you can hold for future appreciation or sell at a later date.
Another common approach is the Cashless Exercise, also known as an exercise-and-sell or same-day sale. With this method, you exercise your options and simultaneously sell all of the acquired shares in the open market. The proceeds from the sale are used to cover the exercise price, tax withholding, and any associated brokerage commissions or fees. The remaining net proceeds are then delivered to you in cash.
Navigating Common NQSO Scenarios
If your employment with the company ends, you do not immediately forfeit your vested options. You are granted a limited time frame, known as the Post-Termination Exercise Period (PTEP), to exercise them. This window is often 90 days from your last day of employment, but the specific duration is defined in your grant agreement. Any vested options that are not exercised by the end of the PTEP will expire and be forfeited.
Another situation is when your options become Underwater. This occurs when the current fair market value of the company’s stock falls below your fixed exercise price. In this scenario, there is no immediate financial benefit to exercising your options, as it would cost you more to purchase the stock than it is worth on the open market. If the stock price does not recover and rise above your exercise price before the expiration date, the options will expire worthless.