Non-Qualified Stock Option
An NSO or Non-qualified stock option is a stock option that does not qualify for the special tax treatment accorded to an incentive stock option. Incentive stock options or ISO’s are only offered to employees of companies with a number of restrictions attached. For regular tax purposes, an incentive stock option possesses the advantage that no income is reported at the time the option is exercised and, if certain requirements are fulfilled, the profits realized when the stock is sold will only be taxed as long-term capital gains. By contrast, an NSO will result in additional taxable income obligations to the holder when the option is exercised—the taxable amount is found in the difference between the exercise price and the market value on the date of exercise.
An NSO stock option is predominantly preferred by an employer, because the issuer is permitted to reduce tax obligations to the amount the recipient is mandated to report in his or her income. If the individual employee has deferred vesting, the individual must comply with the special rules attached to all types of deferred compensation. This ruling was enacted by Congress in 2004 after Enron partook in one of the greatest corporate scandals in American history.
An NSO is a means for a company to compensate their employees or service providers without paying them in cash. The company will grant employees or service providers the option to purchase the underlying shares at a fixed price. The price is determined by the amount the stock is currently traded for. If the stock isn’t publicly traded, the company will determine the value of a single share on the date the NSO is granted. The incentive awarded to the employee or service provider is found in the ability to benefit from the potential increase in stock without having to risk any funds. Because this arrangement is a method of compensation, the employee or service provider is required to report ordinary income when the option is exercised. The amount of taxable income is derived from the excess of the fair market value of the shares received divided by the option price.