What Is a Non-Qualified Stock Option?

Non-Qualified Stock Options, often called NQSOs, represent a common form of equity compensation provided by companies. These options give an individual the right to purchase a specified number of company shares at a predetermined price, known as the exercise or strike price. NQSOs are distinct because they do not meet specific Internal Revenue Service (IRS) requirements for preferential tax treatment. This makes them a flexible tool for companies to incentivize a broad range of service providers.

Non-Qualified Stock Option Fundamentals

A non-qualified stock option grants the holder the ability, but not the obligation, to buy company stock at a fixed price. An NQSO begins on the grant date, when the company issues the option and sets the exercise price, typically at the stock’s fair market value. This grant outlines the number of shares, the exercise price, and the option’s expiration date.

Following the grant, a vesting period dictates when the options become exercisable. Vesting schedules vary, often requiring the individual to remain with the company for a specific duration or achieve certain performance milestones. Until options vest, they cannot be exercised, and unvested options are typically forfeited if employment ceases. A common vesting structure is a four-year schedule with a one-year cliff, meaning no options vest during the first year, and then a portion vests annually thereafter.

Once vested, the individual can choose to exercise the option. Exercising involves purchasing the shares at the pre-established exercise price, regardless of the current market price. The difference between the current market price and the lower exercise price at the time of purchase represents the intrinsic value or “bargain element” of the option. Options have an expiration date, a deadline by which they must be exercised.

Taxation of Non-Qualified Stock Options

The tax treatment of Non-Qualified Stock Options occurs at two distinct stages: at the time of exercise and when the acquired shares are subsequently sold. At the time of exercise, the difference between the fair market value (FMV) of the stock on the exercise date and the exercise price paid for the shares is immediately recognized as taxable ordinary income.

This “bargain element” is subject to federal income tax, along with Social Security and Medicare taxes (FICA). Many states also impose income tax on this amount. For employees, the employer withholds these taxes from their compensation.

When the shares acquired through NQSOs are later sold, any gain or loss realized from that sale is subject to capital gains tax. The cost basis for calculating this capital gain or loss includes the original exercise price paid for the shares plus the amount of ordinary income recognized and taxed at the time of exercise. This adjusted cost basis prevents the same income from being taxed twice.

If the shares are held for one year or less after exercise before being sold, any profit is considered a short-term capital gain and is taxed at ordinary income tax rates. If the shares are held for more than one year after the exercise date, any profit is considered a long-term capital gain, which qualifies for lower tax rates. If the sale price is lower than the adjusted cost basis, a capital loss may be realized, which could potentially offset other capital gains or a limited amount of ordinary income.

Reporting Non-Qualified Stock Option Transactions

Reporting Non-Qualified Stock Option transactions involves specific tax forms. The ordinary income recognized at the time of exercise is reported by the employer. This income is included in the employee’s wages on Form W-2, in Box 1, and is identified in Box 12 with Code V.

When the shares acquired from exercising NQSOs are sold, the transaction is reported by the brokerage firm. This information is provided to the individual on Form 1099-B, which details the proceeds from the sale and the cost basis. The data from Form 1099-B is then used to complete IRS Form 8949, Sales and Other Dispositions of Capital Assets. The information from Form 8949 is summarized on Schedule D, Capital Gains and Losses, which is part of the individual’s federal income tax return.

Key Differences with Incentive Stock Options

Non-Qualified Stock Options differ significantly from Incentive Stock Options (ISOs), primarily in their tax treatment and eligibility criteria. A major difference lies in taxation at exercise: NQSOs’ bargain element (the spread between fair market value and exercise price) is taxed as ordinary income at exercise. In contrast, ISOs do not trigger ordinary income tax at exercise, though they can be subject to the Alternative Minimum Tax (AMT).

The tax treatment upon the sale of shares also varies. For NQSOs, after the ordinary income is recognized at exercise, any subsequent gain or loss when the stock is sold is treated as capital gain or loss. For ISOs, if specific holding period requirements are met (holding the stock for at least two years from the grant date and one year from the exercise date), the entire gain from the sale may be taxed as a long-term capital gain. If these holding periods are not met, the ISO can be treated similarly to an NQSO for tax purposes.

Additionally, employers can take a tax deduction for the ordinary income recognized by employees from NQSOs, which is not the case for ISOs. NQSOs also offer greater flexibility as they can be granted to a wider range of individuals, including non-employees like consultants and board members, while ISOs are exclusively for employees.