What Is A Non-Qualified Stock Option?

To draw in quality employees, organizations frequently offer company stock as a component of their employees pay packages. There are three fundamental types that they offer: motivator investment opportunities such as incentive stock options (ISOs), non-qualified stock options (NSOs), and performance stock units (PSUs).

NSOs are an investment opportunity that are stock options that does not qualify for favorable tax treatment for the employee. Unlike ISOs, where you don’t pay taxes upon exercise, with NSOs you pay taxes when you exercise the options and when you sell those shares.  In addition, the tax you pay on NSOs for the difference in the grant price and the exercise prices is taxed at the option owner’s ordinary income tax rate instead of the more favorable long-term capital gain tax rate.

NSO are offered to keep employees at the company. The idea is that the employee has an incentive for the company to do better and they become owners of the company when they exercise the options. Usually, the company will set a NSO vesting schedule over several years to further help retain the employee.

Since it is expected that the company share prices will increase over time, the employee can potentially acquire the stock at a discount. The NSO has an exercise price that is set at the time the option is granted and this is the price that the employee can buy the stock at. The employee then must pay tax on the difference from the exercise price and the stocks fair market value at the time the NSO is exercised. Once the NSO is exercised, the employee can choose to sell the shares immediately or retain them and sell at a future date.

It should be noted that there may be claw back provisions in NSOs. These provisions may allow the company to take back the NSOs for various reasons such as company insolvency or a buyout so working with a financial planning consultant is important.