What Are Non-Qualifying Stock Options?

A non-qualified stock option means that it does not qualify for favorable tax treatment for employees. But what exactly does that mean? If you are an employee that has access to stock options for compensation or equity compensation in your job, you might’ve heard the term stock options and non-qualifying stock options.

Incentive stock options typically do not require taxes upon exercise but with non-qualifying stock options, the employee pays taxes both when you exercise the option and when you sell those shares.

The main difference between qualified and non-qualified stock options is the taxes paid on them. Any profit made from qualifying stock options are taxed at the capital gains tax rate, which is typically around 15%. This is a lower tax than ordinary income. Any profit or gains from non-qualifying stock options are considered ordinary income and are not eligible for a tax break.

These non-qualifying stock options need to be reported on your paystub and there are no tax consequences when you receive your non-qualifying stock option only when you exercise that option.

What does it mean to exercise your stock option?

To exercise a stock option means to purchase the issuer’s common stock at the price set by the option or grant price regardless of what the stock price is at the time that you purchase it. It only makes sense to exercise those options if they have current value. Stock options that have current value are called “in the money” meaning that the strike price or exercise price of those stock options is lower than the market price of the company shares trading on the exchange.

Employees should exercise this option if the underlying asset prices above the strike price of a call option or if the underlying asset prices below the strike price of a put option. It’s not a given nor is it an obligation to exercise stock options.

Employees can exercise their non-qualifying stock options on any date after those stocks vest up until the grant expiration. When those stock options vest, there are still no taxes due.

Non-qualifying stock options can be used to compensate employees, business partners or even advisors but incentive stock options can only be used to compensate employees. These non-qualifying stock options are taxed at the regular income at the time of purchase and are not eligible for certain tax breaks.

So which are better? Incentive stock options or non-qualifying stock options?

Qualified stocks also called incentive stock options can only be used for employees whereas non-qualifying stock options can be used by anyone including vendors, directors, and employees. There are differences between the two so it really depends on who’s issuing it, who you are issuing it to, and the tax incentives and consequences that follow.

For more clarification on non-qualifying stock options, contact us at any time. We help employers and employees understand their stock options, understand what to do with their stock options, and how to invest and deal with taxes wisely.

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