For many new companies, the desire to attract top talent is of upmost importance.

Given the lack of disposable cash to offer high salaries to new employees, younger firms tend to offer stock option grants as incentive in hopes of a larger payout in the future.

There are two main types of stock option grants that private firms may offer their employees: non-qualified stock options (NSOs) and incentive stock options (ISOs).

(Note: The “non-qualifying” aspect of the NSO refers to the fact that the stock option award does not qualify for favorable tax treatment by the IRS. This is in contrast to the ISO award which is considered to meet the conditions of the IRS to qualify for favorable tax treatment.)

NSO holders are required to pay taxes upon first exercising their options, and again when they dispose of the acquired shares at a later date.

Exercising NSOs

At the point of exercise, the spread between the fair market value of the NSO and the exercise price is added to the employee’s total compensation for the year and is taxed as ordinary income by the IRS. This sum is referred to as compensation income.

To break this down, the “spread” simply refers to the mathematical difference between two values, the two in this case being the Fair Market Value (FMV) and the exercise price. The FMV is derived from an appraisal (also known as the 409A valuation), and the exercise price is given in the original grant from the company.

Disposing (Sale) of Stock

After exercising the option and now owning stock, the holder of such stock is able to hold it for as long as he/she chooses.

When the holder decides to sell the stock, he/she will pay taxes on the difference between the gross proceeds from the sale and the adjusted cost basis of the stock. This, put simply, is the exercise price plus the compensation income (which is that “spread” we mentioned earlier).

Once this difference between the gross proceeds and adjusted cost basis is found, if the holder decides to turn around and sell their stock within one year of the date of exercise, he/she will be subject to ordinary income taxes.

If, however, the stock is sold after a full year of holding it, the gain will be taxed at the long-term capital gains rate, which is lower than the ordinary tax rate.

Summary

• NSOs are non-qualifying because they do not receive special tax treatment and are taxed at two points in time.
• The initial taxable event is at the point of exercise and the “spread,” or difference between the fair market value and the exercise price, is considered ordinary taxable income.
• The second taxable event is at the point of sale of the underlying stock. At this point it is treated as a capital gain and the holder’s tax rate will depend on the duration of holding the stock from the point of exercise - with greater tax efficiency after one year of holding.

Every situation is different. If you want to get in touch with us about yours specifically, give us a call. We’re here for you every step of the way.