We’ve discussed stock options at length on Daily Capital, but people often don’t know that there are two types of stock options: Incentive Stock Options (ISOs) and Nonstatutory Stock Options (NSOs). ISOs are generally what come to mind when people think of “stock options”, but NSOs are also common and how you approach them is slightly different.
What Are Nonstatutory Stock Options?
Nonstatutory Stock Options (NSOs) are also known as Non-Qualified Stock Options (NQOs).
They are typically used by more mature companies for higher-paid employees (as well as contractors, consultants and other non-employees, if companies want to give them more than $100,000 worth annually). Because NSOs do not meet the requirements of IRS Code Section 422, they do not benefit from the (potential) corresponding tax benefits that ISOs do.
Tax Treatment of Nonstatutory Stock Options
Typically, NSOs are taxed at the date of exercise rather than the date of grant.
The amount subject to ordinary income tax is the difference between the fair market value at the time of exercise and the exercise price. If you continue to hold the stock after exercise, any gain in price is subject to capital gains rules (long-term, if you hold for more than 12 months).
For example, let’s say you are granted 300 shares of XYZ, Inc., on January 1, 2016, with an exercise price of $10 per share, with 100 shares vesting each year for the next three years. After the first year, you exercise 100 vested shares when the FMV is $30. The amount reported as ordinary income is $2,000 – (i.e., [$30 FMV – $10 exercise] x 100 shares). Let’s say you hold the stock for one more year and sell when the FMV is $42. The amount subject to capital gains tax then is $1,200 (i.e., [$42 FMV – $30] x 100 shares).
Exercising and Selling Nonstatutory Stock Options
There’s no hard-and-fast rule when it comes to exercising and selling NSOs, but it’s generally a good idea to have more aggressive diversification if they are deep in the money (~33%-plus) and there is no special reason to defer income. Do not let in-the-money options expire.
Our Take: Diversifying After Exercising NSOs
Since NSOs are taxed as ordinary income upon exercise, we generally recommend diversifying right away if you are deep in the money and there is no special reason to defer income (vs. holding and hoping the stock goes up).
If you exercised shares in the past and now hold a material amount of stock, then it can often make sense to start diversifying. It’s usually good to start with the highest-cost, long-term lots first. The amount to sell will likely come down to how much you’re comfortable with. You should consult a tax advisor and a financial professional to learn more.
Have questions about your NSOs or other equity compensation? Schedule an appointment with a Personal Capital advisor.
Disclaimer: The information and content provided herein is general in nature and is for informational purposes only. It is not intended and should not be construed as a specific recommendation, or legal, tax or investment advice, or a legal opinion. Individuals should contact their own professional tax advisors or other professional to help answer questions about specific situations or needs prior to taking action based on this information. Tax laws and authorities are subject to change, either prospectively or retroactively, and any subsequent change could have a material impact on your situation.