Non-Qualified Stock Options Information

What Are Non-Qualified Stocks?

There are essentially two types of stocks for employees: the Incentive Stock Options (ISO) and the Non-Qualified Stock Options (NQSO). The former are those which are taxed at capital gains rates. The former, Non-qualified stocks, are a type of stock option for which employees are taxed at a ordinary income rate.

The reason they are called such is that they don't meet the Internal Revenue Code to qualify as ISOs. Thus, they are simpler than Incentive Stock Options and they are more common, but ISOs offer unique tax benefits that many people consider more favorable.

About Non-Qualified Stock Options

Both Non-Qualified Stock Options and Incentive Stock Options are offered to employees by a company's board of directors. They are usually decided upon as a way to attract employees as well as motivate them. They encourage the employee to buy stock options as a way to offer ownership in the company, which encourages the employee to make beneficial decisions on behalf of the company and work harder to make it profitable.

It's highly recommended that if you are granted stock options by a company, you get a copy of the agreement and read it thoroughly. Some agreements state that an employee cannot exercise their shares until they are vested. Vested is a specified period of time in which they company will allow only a certain percentage of stock ownership or none at all. This is a way of keeping the employee from simply exercising the shares, then selling them right away to make a profit and then leaving hte company. If you decide to exercise your options, make sure the company is withholding federal and state income taxes, as you don't want to owe potentially thousands of dollars on what will be considered compensation come tax time.

Non-Qualified Stock Options and Taxes

With Non-Qualified Stock Options, the individual must consider the income as compensation. In paying tax, one pays the ordinary income tax on the difference between the grant price and the price and the exercise price. Exercising means using your ability to purchase a stock. When you exercise a stock, this refers to the act of buying the stock at the price specified by the option. 

The individual does not need to pay any tax until they exercise the stock. Just because an employee has been granted stock options does not mean they are taxed. Taxes are not paid until the individual decides to exercise the stock and sell it that creates a transaction that is taxable.There are four types of stock option transactions. In one case, you exercise the option to purchase the shares and decide to keep them. Secondly, you can exercise your option to purchase shares, then sell them that very day. This is known as "flipping." Or, you can opt to purchase the shares and sell them in a year or before that. Finally, you can choose to exercise the option to purchase and sell them more than a year later.

Each of these actions calls for different tax issues, and the amount of tax you pay depends upon the timing of when you sell the stock. If you don't sell the shares but decide to hang onto them, this is still considered a profit. The individual is taxed as if they had made the money as income. The compensation comes form the difference between the exercise price (which might be $25) and the market price, according to the market price on the day you purchased the option. This is then multiplied by the number of shares the individual purchased.

If you exercise your option, buy the shares and sell them on the same day, it's still counted as compensation, but it is calculated differently in this case. If you exercise and buy the shares, then sell them in less than a year, the stock sale is also considered short-term. On the other hand, if you sell the stocks more than a year later, it's considered long-term. Thus, you need only pay tax at the rate of capital gains, which is most often lower than the rate of regular income tax.