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What are non-qualified stock options?
Non-qualified stock options are stock options that do not receive favorable tax treatment when exercised but do provide additional flexibility for the issuing company. Gains from non-qualified stock options are taxed as normal income. The company that grants non-qualified stock options can deduct the cost as an operating expense, while no such deduction is available for incentive stock options.
Stock options are granted by certain companies as a form of deferred compensation. They grant employees and certain other parties the right to purchase a given number of the company’s shares at a fixed price — called the grant price or the strike price — after a set amount of time has gone by. Holders generally exercise stock options when the market price has risen above the grant price, giving them a discount on the shares. They either hold the shares obtained in the exercise of a stock option, or sell them immediately for a profit.
Incentive stock options — also referred to as qualified stock options — may only be exercised if the market price is equal to the grant price. If the price is lower than the grant price, it would entail paying a premium for the shares. Non-qualified stock options may be sold at any market price, either higher or lower than the grant price.
While non-qualified stock options carry less favorable tax treatment for the holder than qualified stock options, they offer other benefits. Non-qualified stock options can be issue to anyone — employees, board members, vendors — whereas qualified stock options may only be issued to employees. There are no limits on the total market value of stock that can be exercised by a given holder, while there are strict limitations on the total market value of incentive stock options that can be exercised in one calendar year.
The biggest advantage for companies is that as long as withholding obligations are met, they can deduct the cost of granting non-qualified stock options as an operating expense. These costs are equal to the gain declared by the holder, which he or she reports as ordinary income.
Nonqualified stock options example
An employee exercises his option to purchase stock at a strike price of $25 per share for 100 shares. The current market value of the stock is $45 per share. The employee pays $2,500 for stock that is valued at $4,500. This is a gain of $2,000. Because these are nonqualified stock options, the employee is required to pay income taxes on the $2,000 in compensation.
The employee only pays income taxes on the compensation element once. When he decides to sell the stock, he is required to pay taxes on the gain. The employee may wait until the stock price reaches $50 per share to sell. He would pay taxes on the difference between the sale price ($5,000) and the cost basis ($4,500), which is the actual price paid plus the compensation element.
Thinking of taking advantage of your employee stock options? Find out if these options are right for your portfolio.