Non-Qualified Stock Options (NSOs)

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Non-qualified stock options (NSOs), also known as non-qualified stock options or NQSOs, are a type of stock option scheme in the United States that does not qualify for special tax treatment afforded to Incentive Stock Options (ISOs).
What are the main aims and objectives?

NSOs are used with a multifaceted purpose that serves both employers and employees. At its core, the scheme aims to provide a form of compensation that can help companies attract, retain, and motivate employees. By offering options to buy company stock at a set price, NSOs give employees a vested interest in the company's success; the better the company performs, the more valuable the stock options become. This creates a direct incentive for employees to contribute to the company's growth and profitability.

For employers, the NSO scheme is a valuable tool for managing cash flow and compensation expenses. Since options do not require an immediate cash outlay, companies can conserve capital while still offering competitive compensation packages. Additionally, the scheme can be structured in a way that aligns the granting and vesting of options with company goals and performance milestones, ensuring that the rewards are linked to tangible achievements.

How does the program work?

The Non-qualified Stock Option (NSO) scheme in the United States is a popular form of equity compensation provided by companies to their employees and other eligible service providers.

Unlike ISOs, NSOs are taxed as ordinary income at the time of exercise on the difference between the exercise price and the fair market value of the shares. This amount must be included in the employee's income tax return for that year. When the shares are eventually sold, any further gain or loss compared to the value at exercise is treated as a capital gain or loss. However, if the stock qualifies and is held for over five years, the employee may be eligible for the qualified small business stock (QSBS) exclusion, which can allow for a significant reduction in capital gains tax liability upon sale

Whereas ISOs can only be granted to employees, NSOs can be granted to employees, directors, consultants, and other service providers. NSOs can also often be transferred under certain conditions and may have more flexibility in terms of the term.

NSOs are intended to provide flexibility in compensation. In contrast to qualified stock options, which come with more stringent regulatory requirements and limitations, NSOs offer greater flexibility in terms of eligibility, pricing, and vesting criteria. This allows companies to tailor the scheme to their unique needs and circumstances, and to the specific roles and contributions of different employees.

Options typically have an expiration date, and if they're not exercised by this date, they expire worthless. Common expiration periods range from 5 to 10 years after the grant date.

What is the overall cost?

There is currently no information on the overall cost of ISOs in lost tax revenue.

How was it implemented?

The Non-qualified Stock Option (NSO) scheme in the United States wasn't created through a single event but evolved as a form of equity compensation alongside the growth of the stock market and the increasing complexity of employee benefit offerings.

NSOs grew in popularity, particularly in the tech industry and startups, during the late 20th century and into the 21st century. They became a tool for companies that wanted to offer stock options to a broader range of employees and other service providers without the restrictions that apply to ISOs.

What impact has been measured?

There is currently no available information about the impact of NSOs in the United States. 

What lessons can be learned?

Although NSOs are less generous than ISOs for the employee there are several benefits for companies issuing them instead of ISOs:

  1. Broader Eligibility: NSOs can be issued to a wider range of people, including employees, consultants, advisors, and directors. ISOs are restricted to employees only.
  2. Flexibility in Terms: Companies have more flexibility in setting the terms for NSOs, such as the vesting schedule, exercise price, and expiration period. This allows companies to customize the options to better align with their compensation strategies.
  3. No Alternative Minimum Tax (AMT): Recipients of NSOs are not subject to AMT at the time of exercise, which is a consideration for ISO holders. This simplifies the tax situation for employees, although they will pay ordinary income tax rates on the spread at exercise.
  4. Tax Deduction for the Company: When NSOs are exercised, the company can take a tax deduction for the compensation expense, which is equal to the amount of income the employee is required to report. ISOs do not provide this tax deduction for the company unless the employee disqualifies the ISO by not meeting certain holding period requirements.
  5. No Disqualifying Dispositions: NSOs do not have disqualifying disposition rules that can affect the tax status of the option. ISOs, if not held for the required statutory periods, become disqualified and lose their preferential tax treatment, which can complicate an employee's tax situation.
  6. Less Stringent Requirements: NSOs do not have the same stringent requirements that ISOs have, such as the $100,000 limit on the aggregate fair market value of ISOs that can become exercisable in any calendar year or the requirement that the exercise price must be at least the fair market value of the stock at the time of grant.
  7. Simplicity: NSOs are generally simpler to administer because they do not have the complex rules and qualifications that come with ISOs. This can reduce the administrative burden on the company and make it easier to manage the stock option plan.
  8. Immediate Tax Event: While being taxed at exercise as ordinary income may seem like a drawback for recipients, it does create an immediate tax event. This means employees do not have to worry about future tax liabilities or complexities related to the stock's disposition, unlike with ISOs, which can have tax implications upon sale of the stock if certain conditions are not met.

CURATED BY

Tom Hancock

Research Associate
Global Entrepreneurship Network
United Kingdom