What You Need to Know about Non-Qualified Stock Options
By Echo Huang, CFA, CFP®, CPA
Do you have any non-qualified stock options (NSOs) granted to you by your employer? NSOs are a common equity compensation feature provided to management level employees as part of a compensation package. They give you the opportunity to potentially profit from the price increase in your employer’s stock. An employee stock option gives you the right to purchase a specific number of shares of your company’s stock at a specific price – the grant or strike price – within a specific time period. The grant price is typically the market value of the stock at the time your company granted you the options. Here are some of the essential things you ought to know about your NSOs.
- Vesting Period. Vesting is the time at which you have met the required service period and may exercise the option to purchase the time. You are not required, however, to exercise your options as soon as they vest. Your vesting schedule is contained in your grant agreement. For example, if it is four years cliff vesting, the entire grant will vest after four years from the date you receive this grant.
- Expiration Date. After your NSOs are vested and the current market price is greater than the grant price, it has in-the-money value, then you can decide when to exercise the options to capture the profit. Note that if you don’t exercise your stock options before the expiration date, they will expire with no value. For example, the grant may have four years cliff vesting period and the expiration date is ten years from the date of grant. In this case, you have six years to monitor the stock price to determine the best time to exercise this option. I recommend watching the price closely in the last two to three years before the expiration date.
Tax Treatment. Unlike Incentive Stock Options (ISOs), NSOs do not qualify you for preferential tax treatment. You will pay ordinary income tax on the difference between the grant price and the Fair Market Value of the stock at the time you exercise the option. For example, if the grant price is $40 per share, and you have decided to exercise the options when the market price is $70 per share, then $30 per share is treated as earned income reported on the tax form W-2. Federal, state and local income tax withholdings apply to the profit in addition to the social security and Medicare withholding taxes.
- Exercise Methods. There are three common ways to exercise your NSOs:
A. Same Day Sale/Exercise & Sell All (“Cashless Exercise”). This is probably the most common way. The goal of this type of exercise is to acquire cash, rather than shares of stock. You are not required to use cash to make an upfront payment for exercising your options. Instead, option costs, applicable taxes, and commissions are paid with the proceeds of the sale on the same day. You receive the net proceeds in cash. This exercise can be placed either as a market or limit order.
Please note that as you sell the shares on the same day, your sale price may differ from the closing price (end of the day price), you may incur small short-term capital gains or losses when you receive tax Form 1099. For example, the closing price is $70 per share which is the cost basis of the shares because $70 is used to calculate the profit of $30 per share that is reported as earned income on your tax form W-2. When you sell the shares at $70.25 per share during the day, you will report short-term capital gains of $0.25 per share when you prepare your income tax returns. Make sure that you do not use the grant price of $40 per share as cost basis to calculate capital gains that would cause you to overpay taxes.
B. Exercise and Hold. You use your personal funds to cover the option cost, fees, and applicable taxes. For example, if you exercise 1,000 shares of the option with a grant price of $40 per share when the market price is $70 per share, you would pay for $40,000 plus taxes on the profit of $30,000 and commissions, and receive 1,000 shares of your company stock. You can decide when to sell these shares in the future. If you hold the shares for at least one year from the exercise before you sell, then you would report long-term capital gains or losses. If you hold the shares for less than one year before you sell, then you would report short-term capital gains or losses.
C. Stock-for-Stock Exercise. You can choose to use the company stock you personally own in your brokerage account to pay for the option costs and applicable taxes. This exercise method is done without using a brokerage account. You must contact your employer’s stock plan department to fill out a specific form and certify that you already have enough shares to pay for the total costs. This exercise method has a major benefit for the executives (officer level) who are subject to blackout periods (when they cannot trade the stock several times per year before earnings releases) because they can use existing shares to exercise the option to receive more shares during blackout periods without violating the rules. For example, the option cost of 1,000 shares is $40,000, plus $12,000 (40% total tax withholdings on the profit of $30,000), then you need to submit 743 shares of existing shares to your employer to generate $52,000 when the price is $70 per share. You will then receive 1,000 shares of stock in your account without paying commissions as this transaction is not treated as brokerage transaction. You can decide to sell the shares in the future outside blackout periods.
Which exercise method is the right one? The right answer is “It depends”. In general, cashless exercise is the right way for someone who does not have the cash or stock to pay for the option cost and wants to reduce the concentration risk in the employer stock. Stock-for-stock exercise is generally more appropriate for someone who does not want to use cash up front and wants to increase concentration in the employer stock but doesn’t want to have the leverage feature of options, especially when the expiration date is approaching. Please note that the upside potential to generate profit is decreasing as it’s near the expiration date, therefore monitoring the stock price movement and timing are important.
If you are not familiar with the strategies, what tools to use to monitor stock options and how they would affect your tax situation, you may want to find someone who can help. A good financial advisor may be able to create a financial plan and integrate various option exercise strategies with your overall financial plan.