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Tax Implications of Non-qualified Stock Options
If the United States Internal Revenue Code provides for tax benefits for employee stock options (ESOs) that follow the Internal Revenue Code's requirements, then what happens to those ESOs that do not follow the Internal Revenue Code's requirements and do not fall into either incentive stock options (ISOs) or employee purchase plans (ESPPs)? Are they non-existent? If they do exist then how are they taxed and how different are they from ESPPs and ISOs in terms of benefits to the employees?
There are certain ESOs that are neither ISOs nor ESPPs. They are called non-qualified stock options (NQSOs) also known as non-statutory stock options. These ESOs did not meet some, most or may be all of the requirements set forth by the Internal Revenue Code to qualify for a favorable tax treatment. Because of this, NQSOs are taxed differently from ISOs and ESPPs. Despite the tax treatment difference, NQSOs still provide the basic benefits of ESOs to employees and in the case of NSQOs even to non-employees, and this is to grant a right to the holder (employee or non-employee) to buy the corporation's stock at an option price for a specified period. Because NQSOs are not required to meet any restrictions, the option price can be as low or as high as the employer wants them to be and the period of exercise of the NQSO can be as long as the company wants.
Unlike ISOs and ESPPs, NQSOs can be taxed by the government even at the moment of grant by the corporation provided that the stock option has an ascertainable market value at the time of grant. This tax shall be considered as ordinary income tax from the market value of the NQSO minus the amount paid for the option. After the employee exercises the option, there will be no other income tax implications. If the employee chooses to hold on to the stocks, then he will be taxed with long term capital gains tax measured from the stock price at the time of disposition minus the price paid for the exercise of the option minus the amount in income upon the option's grant. But like a majority of NSQOs, if the ESO does not have a definite market value at the time of grant then the NSQO will be taxed at the time of exercise by the employee, except if they fall under certain restrictions by the government. The difference of the stock price at the time of exercise of the NSQO minus the amount paid to exercise the option shall be taxed as income tax. Tax obligations that fall under NQSOs are governed by section 83 of the Internal Revenue Code.
As a general rule, if the NSQO given to the employee is publicly traded in an established market, then the NSQO will have an ascertainable market value. The stock option itself must be traded and not just the stocks. However, if the NQSO is not traded on an established market then it has no ascertainable market value unless these conditions are met:
1. the NSQO can be transferred by the holder;
2. the NSQO can be immediately exercised in full by the holder;
3. the NSQO and the underlying company stock that is subject of the NSQO does not have any restrictions that will have a significant effect on the NQSO's value; and
4. the fair market value of the NQSO's privilege can be ascertained.
There are certain ESOs that are neither ISOs nor ESPPs. They are called non-qualified stock options (NQSOs) also known as non-statutory stock options. These ESOs did not meet some, most or may be all of the requirements set forth by the Internal Revenue Code to qualify for a favorable tax treatment. Because of this, NQSOs are taxed differently from ISOs and ESPPs. Despite the tax treatment difference, NQSOs still provide the basic benefits of ESOs to employees and in the case of NSQOs even to non-employees, and this is to grant a right to the holder (employee or non-employee) to buy the corporation's stock at an option price for a specified period. Because NQSOs are not required to meet any restrictions, the option price can be as low or as high as the employer wants them to be and the period of exercise of the NQSO can be as long as the company wants.
Unlike ISOs and ESPPs, NQSOs can be taxed by the government even at the moment of grant by the corporation provided that the stock option has an ascertainable market value at the time of grant. This tax shall be considered as ordinary income tax from the market value of the NQSO minus the amount paid for the option. After the employee exercises the option, there will be no other income tax implications. If the employee chooses to hold on to the stocks, then he will be taxed with long term capital gains tax measured from the stock price at the time of disposition minus the price paid for the exercise of the option minus the amount in income upon the option's grant. But like a majority of NSQOs, if the ESO does not have a definite market value at the time of grant then the NSQO will be taxed at the time of exercise by the employee, except if they fall under certain restrictions by the government. The difference of the stock price at the time of exercise of the NSQO minus the amount paid to exercise the option shall be taxed as income tax. Tax obligations that fall under NQSOs are governed by section 83 of the Internal Revenue Code.
As a general rule, if the NSQO given to the employee is publicly traded in an established market, then the NSQO will have an ascertainable market value. The stock option itself must be traded and not just the stocks. However, if the NQSO is not traded on an established market then it has no ascertainable market value unless these conditions are met:
1. the NSQO can be transferred by the holder;
2. the NSQO can be immediately exercised in full by the holder;
3. the NSQO and the underlying company stock that is subject of the NSQO does not have any restrictions that will have a significant effect on the NQSO's value; and
4. the fair market value of the NQSO's privilege can be ascertained.
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