Nonqualified stock options (NSOs)

How do employee stock options work?

With an employee stock option, the recipient can potentially benefit from the increase in the value of the stock during the term of the option. To better understand how employee stock option programs work, it may be helpful to start by reviewing the list at the right of terms commonly associated with this type of equity compensation.

A stock option vocabulary:

  • Exercise: The act of purchasing the shares of stock that are underlying to the option.
  • Grant price: The price at which the stock can be purchased under the terms of the option. This is also referred to as the strike price or the exercise price. Under most plans, this is set at the fair market value of the stock at the time the grant is made.
  • Spread or in-the-money value: The difference between the grant price and market value of the stock at the time of exercise. Presumably, the option would only be exercised when the stock price is higher than the grant price; otherwise, one would lose money by exercising.
  • Option term: The length of time an employee can hold the option before it expires, at which point it is no longer exercisable.
  • Vesting: Requirement(s) that must be met to have the right to exercise an option. Usually pertains to continuation of service for a specified period of time and (in some cases) the meeting of a specified performance goal.

How do all these pieces fit together?

Let's see what happens when a hypothetical company makes stock options available to an employee:

A company grants an employee options to buy a stated number of shares at a defined grant price. The options vest over a period of time and/or when certain individual, group, or corporate goals are met. Once vested, an employee can exercise the option at the grant price at any time over the option term, up to the expiration date.

Categories of employee stock options

There are 2 main, broad categories of employee stock options:

  • Nonqualified stock options (NSOs)
  • Incentive stock options (ISOs).

This discussion centers on nonqualified stock options.

The distinction between them lies in their treatment for tax purposes, and the explanation for NSOs is the simpler of the 2:

The recipient of an NSO is not taxed at the time the option is granted, and is taxed instead when the option is exercised. When an employee exercises an NSO, the spread on exercise (the difference between the fair market value of the stock and the grant price of the option) is taxable to the employee in the same year in which the option is exercised. In fact, it’s included in compensation income, along with salaries and wages, and is reflected on IRS Form W-2 for tax reporting purposes.

Once acquired, the shares are assigned a cost basis equal to the fair market value of the stock at the time of exercise. From there, any subsequent gain or loss realized by the employee upon the sale of the shares will be a capital gain or loss.

If the options are exercised and the applicable shares are sold simultaneously (as is often the case), compensation income will still be recognized, without any, or at most minimal, resulting capital gain or loss on the transaction. Because of mismatches in the way fair market value at exercise is measured and how capital gain or loss is calculated, there is quite often some gain or loss. On an exercise-and-sell transaction, for example, most plan participants have a capital loss equal to the brokerage commission and SEC fees on the sale.

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