Non-qualified stock options are options that give you the right but not the obligation to purchase equity. You will be stuck paying ordinary income tax on the full bargain element.
Non-qualified stock options (NQSOs) are a type of employee stock option that do not qualify for special tax treatment under the US Internal Revenue Code. Incentive stock options (ISOs) are another type of employee stock option that do qualify for such special tax treatment.
One key difference between NQSOs and ISOs is that ISOs are only available to employees, while NQSOs can be granted to both employees and non-employees, such as independent contractors and directors. Another difference is that ISOs have certain restrictions on when they can be exercised and sold, such as being subject to a holding period before they can be sold, while NQSOs do not have these restrictions.
When an employee exercises an NQSO, the difference between the exercise price and the fair market value of the stock at the time of exercise is considered ordinary income, and is subject to federal and state income taxes, as well as employment taxes. The employee will also have a tax basis in the stock equal to the fair market value at the time of exercise, and will owe capital gains taxes when the stock is sold.
Restrictions on NQSOs include that they are not eligible for special tax treatment under the Internal Revenue Code, they are not subject to the same holding period requirements as ISOs, and they can be granted to both employees and non-employees. Additionally, the company issuing the options must have a plan in place that meets certain requirements, such as specifying the number of shares to be reserved for issuance under the plan.
To exercise non-qualified stock options (NQSOs), the holder typically needs to notify the company or the company's stock plan administrator of their intention to exercise the options. The holder will then need to pay the exercise price, also known as the strike price, to the company in exchange for the shares of stock. The payment can be made in cash or sometimes with shares already owned by the holder.
If an employee leaves a company, the rules for what happens to their NQSOs will depend on the terms of the stock option plan and the specific options that were granted. In some cases, options may be forfeited if the employee leaves the company before a certain date, or they may be able to be exercised for a limited period of time after leaving. It's important to check the specific plan details and consult a tax advisor for clarification.
The strike price of NQSOs affects the tax implications in the sense that the difference between the exercise price and the fair market value of the stock at the time of exercise is considered ordinary income and is subject to federal and state income taxes, as well as employment taxes. If the exercise price is lower than the fair market value of the stock, the difference will be subject to these taxes. A higher strike price will result in a smaller difference and thus less taxes. Additionally, a higher strike price will also mean that the employee will have a higher tax basis in the stock, which can affect the amount of capital gains taxes owed when the stock is sold.