What Are Non-Qualified Stock Options?

A non-qualified stock option is an employee stock option wherein the employee pays ordinary income tax on the difference between the grant price and the fair market price at which he exercises the option.

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Key elements of Non-qualified Stock Options:

  • #1 – Grant Date – It is the date when the employee receives the option to buy the stock.#2 -Exercise Price – The price at which the employee can buy the stock from the company.#3 – Expiration Date – The last date to exercise the option.#4 – Clawback Provision – The clawback provisionClawback ProvisionClawback is a clause in an employment agreement or other financial contracts whereby beneficiaries are subject to repay the incentives they received from time to time given the requirements of the benefactor.read more gives the right to cancel the option given to the employee.#5 – Bargain or Compensation Element – The difference between the exercise priceExercise PriceExercise price or strike price refers to the price at which the underlying stock is purchased or sold by the persons trading in the options of calls & puts available in the derivative trading. Thus, the exercise price is a term used in the derivative market.read more and the stock’s market value.#6 – Withholding – The company must withhold a certain amount of cash. It is mainly to cover federal and state income tax withholdingTax WithholdingWithholding tax is a part of the salary an employer withholds from an employee’s compensation and pays to the legal authorities. It is treated as collateral imposed against the taxes an employee is liable to pay during a particular year.read more and the employee’s share of employment taxes.

Examples of Stock Options Non-Qualified

Below are some examples of Stocks options non qualified.

Example #1

A.B Food is a UK based company listed on the London Stock Exchange. Assume the share price of the company is $10. It grants an NQSO at a $10 exercise price. The share value is $20 after one year.

Employees have the following options:

  • Exercise, sell immediately: Immediately sell the stock for $20. They will have $10 per share as income.Exercise, hold for more than a year, sell: If they sell it for $25, the bargain element is $10 (fair value- exercise price) and is taxable when exercised. They will have a $5 long-term capital gain (S.P of $25-Value at exercise date $20).Exercise, hold for less than 12 months, then sell: Here, $5 gain becomes a short-term capital gain.Employees can exercise an option even if the value is less than the exercise price. Usually, it happens when there is a chance to increase value in the future, but the expiration date is nearing.

Example #2

Mr. Bill is an employee of a US-based company named Marvell Technology Group Ltd. He receives options on a stock that is actively traded on NASDAQ.

He purchased 1,000 shares of company stock and was granted the option to purchase stock. It’s taxable only when he exercises those options and later sells the stock he purchased.

There are four scenarios –

The exercise date is 30th June 2017. Bill exercised the option for $20. The current price is $40. It has not yet sold. There are 100 shares in total.

Compensation element can be calculated as:

Difference between the Exercise Price and Current price multiplied by several sharesNumber Of SharesShares Issued refers to the number of shares distributed by a company to its shareholders, who range from the general public and insiders to institutional investors. They are recorded as owner’s equity on the Company’s balance sheet.read more bought.

$(40 – 20) = $(20 x 100)= $2,000.

Now, the employer will include this compensation element amount ($2,000). Therefore, Mr. Bill will be taxed on the compensation element.

The exercise date and sales day are the same as 30th June 2017. The exercise price is $20. The current market price is $40 and the sales price. And $10 is a commission paid for salesCommission Paid For SalesSales commission is a monetary reward awarded by companies to the sales reps who have managed to achieve their sales target. It is an incentive geared towards producing more sales and rewarding the performers while simultaneously recognizing their efforts. A sales commission agreement is signed to agree on the terms and conditions set for eligibility to earn a commission.read more. There are 100 shares in total.

The compensation element will be the same as $2,000, and the employer will include $2,000 in income.

He sold the stock right after he bought it; the sale counts as short-term, and $10 is a short-term capital lossCapital LossCapital Loss is a loss when the value of the consideration received from the result of the transfer of capital assets is less than the aggregate value of the cost of acquisition & cost of the improvement. In simpler words, it can be stated as the loss derived from the transfer of capital assets.read more.

He sold the stock for $4,490 that he purchased for only $2,500.

The exercise date is 30th June 2017. The exercise price is $20.

The current market price is $40. He sells the shares before 30th June 2018 at $50.

And $10 is paid as a commission. So there are 100 shares in total.

The bargain element of $2,000 is taxable income. The stock sale is considered a short-term transaction deal because he owned the stock for less than a year. The short-term capital gain is the difference, i.e., $490.

In the examples above, if the shares are sold post one year. Again, the gain will be long-term capital gain.

The bargain element is $2,000. The stock sale gain is $490. So he has to pay a marginal tax on the capital gain.

Reasons to Consider Non-Qualified Stock Option

  • It’s an alternative compensation to employees, thus reducing cash compensation.It encourages loyalty to the company.Smaller and younger businesses with limited resources can also be used as a recruiting tool to make up for shortcomings in the salaries offered when hiring talent.It shares the risks and diversifies them in a growing business.It provides increased compensation when an organization can’t afford to raise salaries.It recognizes the contributions of key employees.It avoids the complexity of incentive stock optionsIncentive Stock OptionsIncentive Stock Options, also known as Qualified Stock Options, are employee compensation type that gives them the right to buy the Company’s stock at a price lower than the current market price. Furthermore, businesses use them to retain their top-tier employees for the long run. read more.It issues stock options to employees who aren’t eligible for ISO.

Reasons for Non-Qualified Stock Options Not Being Used

  • If cash compensation is removed, insufficient cash salaries may be an obstacle to recruiting suitable employees.It does not give special tax treatment to employees like ISO.

Difference Between Non-Qualified Stock Options and Incentive Stock Options

Conclusion

A non-Qualified Stock Option is one way to reward employees. It also gives greater flexibility to recognize the contributions of non-employees. It is a valuable part of an employee compensation package, especially if the company’s stock has been soaring of late. Non-qualified stock options are also very relevant for the employer. The amount of the compensation element is generally deductible as a compensation expense.

This article is a guide to Non-Qualified Stock Options and their definition. Here we discuss the key elements of Non-Qualified Stock Options along with examples & uses. You may learn more about accounting from the following articles –

  • Stock DividendStock Options vs RSUEuropean vs American OptionQualified Dividends Definition