Depending upon the tax treatment of stock options, they can be classified as either qualified stock options or non-qualified stock options. Gains from non-qualified stock options NQSO are considered ordinary income and are therefore not eligible for the tax break. NQSOs may have higher taxes, but they also afford a lot more flexibility in terms of whom they can be granted to and how they may be exercised. Companies typically prefer to grant non-qualified stock options because they can deduct the cost incurred for NQSOs as an operating expense sooner.
More details about the differences, rules, and restrictions of qualified and non-qualified stock options are provided below along with example scenarios.
Stock options are often used by a company to compensate current employees and to entice potential hires. Employee-type stock options but non-qualified can also be offered to non-employees, like suppliers, consultants, lawyers , and promoters, for services rendered. Stock options are call options on the common stock of a company, i.
Employees hope to profit from exercising these options in the future when the stock price is higher. The date on which options are awarded is called the grant date. The fair market value of the stock on the grant date is called the grant price. If this price is low, and if the value of the stock rises in the future, the recipient can exercise the option exercise her right to buy the stock at the grant price. This is where qualified and non-qualified stock options differ.
With NQSOs, the recipient can immediately sell the stock she acquires by exercising the option. This is a "cashless exercise", because the recipient simply pockets the difference between the market price and the grant price.
She does not have to put up any cash of her own. But with qualified stock options, the recipient must acquire the shares and hold them for at least oneyear. This means paying cash to buy the stock at the grant price.
It also means higher risk because the value of the stock may go down during the one-year holding period. The IRS and SEC have placed some restrictions on qualified stock options because of the favorable tax treatment they receive.
Why do people use qualified stock options in spite of these restrictions? The reason is favorable tax treatment afforded to gains from QSOs. No taxes are due when qualified stock options are exercised and shares are purchased at the grant price even if the grant price is lower than the market value at the time of exercise. When non-qualified stock options are exercised, the gain is the difference between the market price FMV or fair market value on the date of exercise and the grant price.
This gain is considered ordinary income and must be declared on the tax return for that year. Now if the recipient immediately sells the stock after exercising, there are no further tax considerations. However, if the recipient holds the shares after exercising the options, the FMV on the exercise date becomes the purchase price or "cost basis" of the shares. Now if the shares are held for another year, any further gains are considered long-term capital gains.
If shares are sold before that timeframe, any further gains or losses are counted towards ordinary income. Now let's take a look at the different scenarios and calculate the tax implications. Scenario 1 is the classic qualified stock option. No income is declared when options are exercised and no taxes are due in Scenario 2 is an example of a disqualifying disposition even though the plan was a qualified stock option plan.
The shares were not held for one year after exercise, so the tax benefits of a qualified ISO are not realized. Scenario 1 and Scenario 2 under the non-qualified category represent the same situation when the grant was under a non-qualified stock option plan.
In Scenario 1, the shares are purchased and held for more than one year. In Scenario 2, shares are not held for more than one year. So the further gains are also considered ordinary income. Finally, scenario 3 is a special case of scenario 2 where the shares are sold immediately after they are acquired. This is a "cashless exercise" of the stock options and the entire profit is considered ordinary income.
If you read this far, you should follow us: Log in to edit comparisons or create new comparisons in your area of expertise! Options can be exercised at any time after they vest. Must wait at least one year from the date QSOs are granted before exercising them. Exercise Price May have any exercise price Exercise price must be at least equal to the fair market value FMV at time of grant. Tax consequences recipient No tax at the time of grant.
The recipient receives ordinary income or loss upon exercise, equal to the difference between the grant price and the FMV of the stock at date of exercise. No tax at the time of grant or at exercise. Capital gain or loss tax upon sale of stock if employee holds stock for at least 1 year after exercising the option. Tax consequences company As long as the company fulfills withholding obligations, it can deduct the costs incurred as operating expense.
This cost is equal to the ordinary income declared by the recipient. No deductions available to the company. Holding Period No restrictions Once options are exercised, the employee owns the stock.
She must hold the stock for a minimum of one additional year before selling the shares. When the one year holding period has elapsed, the employee can sell the stock. Transferable May or may not be transferable Must be nontransferable, and exercisable no more than 10 years from grant. How Stock Options Work Stock options are often used by a company to compensate current employees and to entice potential hires. The recipient must wait for at least one year after the grant date before she can exercise the options.
The recipient must wait for at least one year after the exercise date before she can sell the stock. Only employees of the company can be recipients of qualified stock options issued by the company. Options expire after 10 years. The exercise price must equal or exceed the fair market value of the underlying stock at the time of grant. Options are non-transferable except by will or by the laws of descent.
Can be issued to anyone, e. Exercise price must be at least equal to the fair market value FMV at time of grant. No tax at the time of grant. As long as the company fulfills withholding obligations, it can deduct the costs incurred as operating expense. No limit on the value of stock that can be received as a result of exercise.
Once options are exercised, the employee owns the stock. Must be nontransferable, and exercisable no more than 10 years from grant.More...