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How Non-Qualified Stock Options Work

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My wife works in a management position at a local biotech startup and in that role she’s granted non-qualified stock options from time to time. I wrote about pre-IPO stock options over two years ago but since then she’s received “post-IPO” non-qualified stock options. Since it’s getting to be the end of the year, I’m doing some research as to how the capital gains works and it turns out that stock options are pretty easy to understand.

First, there are incentive stock options and non-qualified stock options. There are several differences but the one that really matters is how they are taxed. This article will focus on non-qualified stock options, non-qualified referring to how they are not qualified for special treatment (incentive stock options are treated differently).

How my wife’s stock options work is that she’s awarded X shares, say 1000 shares, at a grant price, say $10.00, on a certain day. The shares vest over a number of years, say 4 years. So next year she gets 250 shares at $10, the year after she gets another 250 shares at $10, etc. She currently has the options but she can’t exercise them until they vest. That’s the basic vocabulary.

How are these taxed? When you exercise the option, 250 shares at $10, you are immediately taxed on the difference between the market price and your exercise price ($10). If the market price is $12 when you exercise, then you will immediately be taxed on $500 ($2 x 250 shares) of capital gains. You can hold the shares, you can sell them, but you are already on the hook for $500 of capital gains. From there on for tax purposes, it’s as if you bought the shares at $12.

When Should You Exercise Your Options?

So I had this chat with my wife and the first thing she thought of was to exercise the stock options when the stock is at its lowest value. On the face of it, it seems to make sense. The smaller the difference between your grant price and the market price, the less you are taxed. However, you earn less too. It doesn’t matter which tax bracket you are in, you are taxed less than what you earn. In the highest tax bracket of 35%, you keep 65 cents on the dollar; you want the price to be as high as possible before you exercise. The key is to maximize income, not minimize tax.

In reality, you balance your need for the money with the market price of the stock. You always want to exercise at the highest price possible but you have to balance that with whether you need the money or when the options expire. When you exercise, you want to sell immediately. There is no benefit to holding onto the shares. If you wanted the shares in the first place, you could’ve bought them on the open market. By keeping your shares, you run the risk of being taxed on income you will never realize.

This is all based on my own web research, I’m not a tax professional so please consult with a tax accountant or attorney before making any decisions.

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7 Responses to “How Non-Qualified Stock Options Work”

  1. Eric N. says:

    It sounds confusing to me lol. What does exercising even mean?

  2. jim says:

    Exercising means you’re buying the shares you were awarded at the grant price.

  3. Anonymous says:

    I enjoy reading your blog but it does not work as you wrote. Your wife’s option if exercised as in your example would give her ordinary income of $2 per share or $500 which would be included on her w-2. Also she would have to pay for the shares( option to purchase at 10). Normally the options are exercised and the shares are sold simultaniously. 250 shs at $12 for $3000 less the purchase price $2500 for a $500 profit. The company then withholds taxes federal including Fica and state( lets say 40%) netting $300.

    You can purchase and keep the shares but then you probably need to come up with the tax withholdings. I used 40% based on a 28% federal tax; 7.65% fica/ medicare and 4.35% for state income tax.

  4. jim says:

    Does it have to do with whether it’s pre-ipo or post-ipo? Everywhere I’ve read has explained it the way I explained it in the above…

  5. Anonymous says:

    I am not sure but this example is post ipo or non qualified and is how it has worked for a number of my clients. I would assume it works the same for ipo shares since you have an option to purchase at a cetain price. Presumably the shares are worth more than the option price when exercised. I have no experience with a a pre ipo option.

  6. Bill says:

    In your research, did you ever come across a situation like this?

    I recently left a pre-IPO company with 1000 vested incentive stock options. These 1000 options vested in September of 2007, and I had to pay income tax (for the 2007 year) based on the stock price at that time. At this time, the options are unable to be exercised or sold, and there are no plans for this to change. It seems to me that since I was forced to pay income tax, I should have some sort of a tangible asset that could actually be sold…

  7. nef says:

    hey, props for the example, i got a question related to this. I have just accepted’Nonqual’ grant offered to me by the company i work for. I have x number of shares at a given price totaling a certain amount.
    Im a bit confused, are the shares there for me to buy at that price? Or sell??

    Props!


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