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What Are Non-Statutory Stock Options?

Byline profile imageWritten by Lee Huffman
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Byline profile imageEdited by Jeff White, CEPF®
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Stock options are a way to reward employees with increased compensation. This also encourages employees to think about themselves as stakeholders in the company’s success and act accordingly. One form of stock options is non-statutory stock options (NSOs), which are generally offered without any restrictions. This flexibility offers additional value, but also adds complexity as well. In this article, we’ll define what NSOs are, share pros and cons and explain how they are taxed.

Consider working with a financial advisor as you decide what to do with your non-statutory stock options.

What Are Non-Statutory Stock Options?

Non-statutory stock options, also called non-qualified stock options, are a form of compensation that gives an employee or other recipient the right to purchase company stock at a predetermined price, known as the exercise or strike price. Unlike incentive stock options (ISOs), non-statutory options do not receive the same special tax treatment under the Internal Revenue Code.

An employer might grant an employee the right to buy shares for $20 each, for example. If the stock later rises to $35, the employee could exercise the option and purchase shares at the lower $20 exercise price. The $15 difference between the stock’s fair market value and the exercise price is commonly called the spread or bargain element.

For most non-statutory stock options, there is generally no taxable income when the options are initially granted because their fair market value cannot be readily determined at that time. When the employee exercises the options, however, the spread between the stock’s fair market value and the exercise price is generally treated as ordinary compensation income. For employees, this amount is typically reported on Form W-2 and may be subject to income tax withholding as well as Social Security and Medicare taxes.

Taxes can also arise when the employee later sells the shares. The employee’s basis generally includes the exercise price plus the amount already recognized as compensation income. Any additional increase or decrease in value after exercise is generally treated as a capital gain or loss, with the applicable tax treatment depending in part on how long the shares were held after exercise.

Pros and Cons of Non-Statutory Stock Options

While there are significant benefits to both employers and employees with NSOs, there are disadvantages as well. It pays to understand both sides of the coin before you exercise these stock options.

Pros

  • Increase employees’ compensation without creating an expense for the employer. Companies are free to adequately compensate employees without worrying about the expenses hurting the bottom line or quarterly results.
  • Generates goodwill with employees. Employees appreciate the recognition that comes with a larger paycheck, and they can participate in the growth of the company. This attitude often leads to behaviors that increase revenue and reduce expenses.
  • Tax benefits for the company and employees. Employees can choose when to exercise their NSOs to reduce the impact on their personal taxes. The profits that employees earn when exercising NSOs can be deducted by the company.

Cons

  • Bigger tax burden on employees. NSOs are treated as ordinary income, which is usually taxed at the highest rates. For employees near the top of their tax bracket, NSO income may be taxed at an even higher rate.
  • No guarantee of future value. Anytime that you invest in stocks, there’s no guarantee that they’ll have value in the future. This is especially true with stock options where you only profit if the stock goes higher before the NSOs expire.
  • Exercising quandary. To exercise your NSOs, you either need to have the cash to pay the taxes or be willing to sell some shares to cover taxes and fees. Some employees do not have the cash available and selling shares means missing out on future growth.

Incentive Stock Options vs. Non-Statutory Stock Options

Digital share price chart

Incentive stock options (ISOs) and non-statutory stock options (NSOs) both give recipients the right to buy company shares at a set exercise price, but they differ significantly in eligibility and tax treatment. ISOs can generally be granted only to employees, while NSOs may be awarded to employees, directors, contractors and other service providers.

With NSOs, the difference between the stock’s fair market value and the exercise price is generally treated as ordinary compensation income when the option is exercised. Employees may also owe payroll taxes on that amount. Any additional gain or loss after exercise is generally treated as a capital gain or loss when the shares are later sold.

ISOs can receive more favorable federal tax treatment if certain requirements are met. Exercising an ISO generally does not create regular taxable income at that time, although the spread may be included when calculating the alternative minimum tax (AMT). If the shares are held for more than two years after the grant date and more than one year after exercise, the gain from the exercise price to the eventual sale price can generally qualify for long-term capital gains treatment.

If the ISO holding-period requirements are not met, the sale is considered a disqualifying disposition. In that case, part of the gain may be taxed as ordinary income rather than entirely at long-term capital gains rates.

The trade-off is that ISOs come with more restrictions, while NSOs tend to offer employers greater flexibility. Employees comparing the two may want to consider the exercise price, expected stock growth, holding period, cash needed to exercise and potential exposure to ordinary income tax, capital gains tax and the AMT.

Since gains from incentive stock options (ISOs) are taxed as capital gains, rather than ordinary income, many companies choose to issue them first. However, ISOs are limited to vesting $100,000 per year. Anything above that amount is treated as NSOs, which are taxed as ordinary income. ISOs can only be issued to employees of the company, while NSOs can be granted to anyone. The grant price of ISOs must be at least the fair market value on the day they are issued. NSOs can be granted at a lower price, but that can trigger tax consequences.

Both types of stock options offer benefits for companies and their employees. Companies may choose ISOs, NSOs or a combination of the two to provide employees with additional compensation.

How Are Non-Statutory Stock Options Taxed?

NSOs are taxed when an employee exercises the options, not when they are granted. This means that the employee has control of when and influence over how much they are taxed. Ordinary income taxes (similar to wages) are owed on the difference between the fair market value and the strike price. These profits are reported as W-2 wages from your employer.

If you exercise NSOs at $33 with a strike price of $13, then you’ll have a profit of $20 per share. For someone with 1,000 NSOs, that’s a gain of $20,000 that is taxed as ordinary income. This type of income generally has the highest tax rates. Depending on your other income sources, this could push you into a higher bracket.

When you sell the shares, any profits that you make are taxed as capital gains. If held less than a year, you’re subject to short-term capital gains rates. When held longer than a year, the profits are taxed as long-term capital gains.

Bottom Line

Two investors watching the market

There are several types of stock options. NSOs can be used to increase employee compensation without impacting a company’s bottom line. Companies can grant as many NSOs as they like and non-employees, like consultants and board members, can receive them as well. When NSOs are exercised, profits are taxed as ordinary income and are included on the employee’s W-2. After the employee exercises the options and receives their shares, normal capital gains rules apply against any future sale.

Tips for Investing

  • NSOs can be an important component of your retirement planning. You can forecast how much their value can increase over time by using our investment calculator.
  • A financial advisor can help you develop an exercise strategy to minimize the impact of taxes so you can keep more of your money. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.

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