What Is a Nonqualified Stock Option?


Note: If you are unfamiliar with stock options, then you probably should read this post before moving on.

If a stock option plan does not meet the IRS requirements for an incentive stock option (ISO) plan, then by default it is a nonqualified stock option plan (nonqual). Sometimes referred to as NQOs or QQSOs, nonquals do not provide any special tax treatment for holders. Nonquals can be granted to employees and nonemployees, as well as independent contractors and so on.

At the time of the grant, there is typically no taxable gain. The exception is if the current fair market value is higher than the exercise price – that is, when the option is in-the-money. But this is fairly rare. There is also no tax when the nonqual vests.

Instead, you will owe taxes when there is an exercise. In most cases, this requires that you come up with the cash to buy the stock. But if the company is publicly traded, it may provide for a cashless exercise. This means that a broker will make a temporary loan to exercise the option and then you will sell some or all of the stock to pay off the liability.

When you exercise the stock, you will recognize compensation income. In other words, it’s as if you earned wages – and this means you will be subject to ordinary tax rates. This will be the difference between the current FMV of the stock and the price you paid for the shares.

Example: A company grants you a nonqual to buy 4,000 shares at $10 each. A year goes by and 1,000 shares vest.  You exercise the option by paying $10,000 for the shares. But the current FMV of the stock is $15. In this case, you have compensation income of $5,000 ($15,000 value of the stock minus the amount you paid).

If you are an employee of the company, then there will be withholding on your W-2. Oh, and it does not matter if you have a tough time selling the shares! You will still need to pay cash for the taxes owed.

As is often the case, the withholding may not be enough. What to do? You may consider making estimated payments to cover the tax bill.

Now, if you are not an employee, then you will get a Form 1099-MISC. It will show the gross proceeds of the exercise of the nonqual. Again, you will owe ordinary taxes on this and it is also probably a good idea to do estimated payments.

OK, then what happens when you sell the stock? If you do so under one year from the exercise, you will have a short-term gain or loss. If not, you will get a long-term gain or loss, of course.

To determine the amount, you need to make adjustments. To see, let’s continue our example: You sell 1,000 shares of the company after one year of the exercise of the nonqual. The total value comes to $30,000.

But you do not have to pay taxes on the whole amount. Rather, you need to figure out your basis. Part of this will be the amount you already paid for the stock, which was $10,000. But you also include the compensation income recognized: $5,000.

You then subtract these from the total proceeds of the sale:

$30,000 – $15,000 = $15,000

Thus, you will have a $15,000 long-term capital gain.

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Tom Taulli

Tom Taulli (Ventura, CA) is founder of the online investment company WebIPO and is the author of The Streetsmart Guide to Short Selling. 10 Illustrations

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