NSOs and Taxation Part 1

Have you been offered non-qualified stock (NSO) options at work, and you are not sure what they are or what to do? First, we will take a few minutes to simply explain what they are, and then the benefits and risks you should consider. In the end, we will give you a few recommendations if or when you decide to take advantage of these puppy dogs. Stay tuned for that. If you are interested in taking a deep dive into the taxation of NSOs, then Part 2 of the article is written for you. But let’s first answer the question, “What are these things?”

What In The World Is An NSO?

The quick answer is that NSOs are a special compensation treat from your employer. They allow you to buy company stock at a set price “down the road.” This price is called the exercise price, and it’s determined when you receive the NSOs. We call the “down the road” a vesting schedule determining when and how many shares you can buy. You will typically spread your stock buying fun at the exercise price over a 1-to-4-year period in lots. But if you snooze, you lose! Meaning if you don’t act within the specified timeframe, you miss out on the opportunity to buy at that sweet exercise price. And trust us; you wouldn’t want to miss out on a good deal. All these attributes make up what is called the grant. For example, you may have the option to buy 1000 shares for an exercise price of $1 per share, 250 shares one year from now, and 250 shares each year after that for the next three years. Your special compensation treat is the difference between the price at which you buy (market price) and the price you actually pay (exercise price). I like to use this equation: (Market $ – Exercise $) x Share # = Compensation

What’s In It For Me?

Now, let’s talk about the benefits. NSOs are a potential win-win situation for both you and your employer. Employers like NSOs because it allows them to delay compensation and incentivize loyalty. Being non-qualified, employers can give NSOs to some employees but not others. Together, delaying compensation through the vesting schedule and deciding who gets NSOs are a strategy to retain valuable team members. On the flip side, NSOs give you a chance to share in your company’s success. You get to be part of the potential upside, and you only pay taxes when you exercise the option and receive compensation. It allows employees to decide if the NSO is a good deal and manage their tax liability. 

How Are They Risky?

But wait, there are risks involved too. What if the company’s stock doesn’t appreciate as expected? You wouldn’t want to exercise your option to buy company stock worth only fifty cents and pay your exercise price of $1! That would never happen, but it illustrates that your NSO could become worthless. And it’s never a good idea to put all your eggs in one basket. If you rely too heavily on your company’s success, you might be financially pickled if things go south. Remember Enron? Yeah, you don’t want to be in a sticky situation like that. So, it’s always smart to diversify your investments and not go overboard with company stock. A good rule of thumb is to have no more than 10% of your nest egg in company stock. Remember, too, that if you load up on NSO company stock and get sizeable compensation on your paycheck, you pay a hefty tax bill, but you haven’t realized any bank account expansion until you sell your company stock. So, the compensation you have remains locked up.

The Robbers In Suits Want Their Share

Now, let’s talk taxes. First, you already had to pay taxes on the compensation. Remember, our equation (Market $ – Exercise $) x Share # = Compensation? That compensation is reported on your paystub, and your employer withholds ordinary income tax, Social Security, and Medicare taxes. Depending on the amount of compensation from the NSO, that could take quite a bite out of what you see in your bank account on payday because your employer isn’t giving you any actual cash.You’ll pay Uncle Sam even more when you want to unlock your compensation. If you sell the stock at a gain, you will pay either ordinary income tax or capital gains tax. The way that works gets complicated, so check out Part 2 of the article if you want to nerd out. Of course, there are also state and local taxes to consider. Be sure to talk with a tax professional that knows your state’s rules because some of them have special treatment for NSOs. You don’t want any surprises when tax season rolls around.

What Should You Do?

Here are a few tips to remember if you intend to or have exercised your NSOs. First things first, if you decide to take advantage of your NSOs, make sure you understand the process and notify your employer before they expire. Second, double-check that the proper taxes have been withheld when that paycheck comes in with NSOs as compensation. If you have other gains from NSO sales, be sure to make an estimated quarterly payment to the IRS for that as well. Finally, schedule an appointment with us to determine what to do with your shares. Should you sell them or hold onto them as a long-term investment? We will help you to understand your NSO situation and give you confidence before you make a decision. We are adept at examining your company’s financials and giving a recommendation that is in your best interests. And there you have it, a fun and simplified guide to NSOs. Now go out there and exercise those options!Want to know more about other alternate forms of employer compensation? Check out the links below.

Incentive Stock Options (ISO)

Restricted Stock Units (RSU)

Employee Stock Purchase Programs (ESPP)

Non-Qualified Deferred Compensation (NQDC)