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The Executive's Guide to Non-qualified Stock Options (NSOs)

Updated: Oct 29, 2023

Executives Need a Plan for Company Stock Options

Employer stock options can give you all of a stock’s upside without risking a penny. But maximizing their value requires a deep understanding and strategic monetization plan.


Executives who fail to plan accordingly may not only miss out on thousands of dollars but could turn what should be an asset into a liability.


This blog will teach you what you need to know to convert your options to cash.


What are the Types of Employer Stock Options?

There are two kinds of stock options.


  • Incentive Stock Options, referred to as ISOs

  • Non-qualified Stock Options, referred to as NSOs or NQSOs


There are a lot of similarities between them, but there are enough material differences to warrant separate blog posts.


Today, we’re diving into NSOs.


What is an Employer Stock Option?

A stock option grant is your company saying,


“Hey, our stock is currently valued at $xx. We think it’s going to be worth more in the future, and since we value you so much, we’re giving you these stock options so you can buy future stock at today’s price.”


Sounds great, right? Let’s unpack a few things.


Employer Stock Option Basics

First things first, an option gives you the right, but not the obligation, to buy stock at a set price in the future.


When you receive an option, your company is making a grant or award. The day you receive it is the grant date.


When you exercise an option, the price you pay for the stock is called the exercise or strike price. It’s usually equal to the Fair Market Value (FMV) of the stock on the grant date.


For public companies, the FMV is the market price. For private companies, the FMV is the 409A valuation.


Before you exercise an option, the option needs to vest or be vested. Options typically vest in equal parts over a three to four-year vesting period as long as you still work for the company. If you leave the company before an option vests or before you exercise, you forfeit the option.


When you exercise an option, you’re telling the company, “Hey, I’m going to take you up on that offer to buy the stock.”


Considering Your Options

An option only has value if you can use it to buy shares at a discount or “get a bargain.”


  • If the option’s exercise/strike price is LESS than the current FMV, it’s considered “in the money.”

  • If the option’s exercise/strike price is MORE than the current FMV, it’s considered “underwater.”


When you exercise an “in the money” option, the difference between the exercise/strike price and the FMV is called the bargain element or spread.


Public vs. Private Company Stock Options

Now is a good time to point out that the tax impact of exercising options and selling shares is the same for public and private companies, but the monetization process can be very different.


Shares of publicly traded companies are typically very liquid, and their option plans are administered by large broker-dealers. This facilitates a smoother, less cash-restrictive process compared to private companies with little to no liquidity.


We'll touch on these differences later in the post.


Stock Option Exercise Framework

Exercising an option triggers a series of events that require a well-thought strategy planned far in advance of the exercise date. You’ll need to consider:


1. How to pay exercise costs + taxes

2. When and what option(s) to exercise

3. Holding or selling the exercised shares


Exercise Logistics

The terminology and mental frameworks above apply universally to Non-qualified and Incentive stock options. From an employee's perspective, the taxable event at exercise is the first distinction between the two option types. The paragraphs below focus exclusively on NSOs.


We’ll assume you exercise an option to buy 1,000 shares with a $20 strike price when the stock’s FMV is $120.


Once exercised:


1. You’ll pay $20,000 to buy the shares (1,000 shares x $20 strike price)

2. Your employer will need to withhold taxes on the $100,000 bargain element [($120 FMV - $20 SP) x 1,000 shares]


Stock Option Tax at Exercise

The $100,000 bargain element is taxed as compensation income.


This means the bargain element is included in your W-2 wages and subject to federal, state, local, Social Security, and Medicare taxes.


If you earn >$200k, you're also charged the 0.9% Medicare surtax.

SS taxes aren't withheld if you already reached the SS wage limit of $160,200 (2023).


Stock Option Tax Withholding

Like other forms of equity comp, the NSO bargain element is considered "supplemental income" for federal taxes.


Supplemental income is taxed at ordinary income tax rates, but the IRS requires the first $1M of supplemental income be withheld at 22% and anything >$1M be withheld at 37%.


Your employer will also need to withhold cash for all other taxes you’re subject to. We’ll assume the following withholding figures:


State: 2.5%

Local: 1%

Medicare: 1.45%

Medicare surtax: 0.9%

Social Security: N/A


Stock Option Exercise Math

Here’s how the numbers shake out:


Option cost: $20,000

Tax withholding: $27,850

Federal: $22,000 ($100,000 x 22%)

State: $2,500 ($100,000 x 2.5%)

Local: $1,000 ($100,000 x 1%)

Medicare: $2,350 ($100,000 x 2.35%)


So, to exercise the option, you’ll need $47,850.


The shares you buy with the option are worth $120,000, so you’re getting a great deal, but what can you do if you don’t have $48,000 lying around?


Cashless Exercise

Companies want to make option exercise accessible to their employees. So, many public companies allow the plan’s broker-dealer (Fidelity, Schwab, etc.) to facilitate what’s called a cashless exercise.


In a cashless exercise (also called “sell-to-cover”), the broker-dealer loans you cash to buy the shares and pay tax withholding, then immediately sells the number of shares necessary to repay the loan. This happens nearly simultaneously, but it occurs in two separate steps.


Following our example, a cashless exercise would leave you with 601 shares [1,000 shares – ($47,850/$120)] or $72,150 (601 shares x $120) if you decided to sell all shares at exercise.


Exercising Private Company Stock Options

Unfortunately, you can’t use a cashless exercise with private stock because the stock is usually illiquid or restricted from selling. In the previous example, you would need to come up with $48,000 out of pocket to exercise the option.


However, the exercise price and bargain elements are likely to be much smaller for start-up or pre-IPO stock, so cash for private stock exercise may be a fraction of the cash needed to exercise public company options.


Early Exercise of Private Stock Options

Many private companies with IPO aspirations allow employees to exercise options before they vest. The early exercise may allow employees to buy stock when the strike price is less than a dollar and there’s little to no bargain element/tax impact.


This drastically reduces out-of-pocket costs and sets up any future appreciation to be taxed as long-term capital gains for potentially huge tax savings.


However, start-up company stock is like a lottery ticket. It could have no value in the future, or you could be forced to sell it back to the company at the exercise price if you leave for another job.


This leaves you to weigh the potential sunk cost of the option price and taxes paid if the stock ends up worthless vs. potential future tax savings.


Stock Option Tax at Sale

Once exercised, your basis in the shares becomes the FMV at the time of exercise. So, if you elect to sell all the shares immediately, there are no future tax consequences.


  • If you decide to hold the shares and sell for a gain within a year of exercise, the gain will be taxed at your ordinary tax rate.

  • If you wait more than a year from exercise, the gain will be taxed at long-term capital gains rates.

  • If the price falls, you can sell and take a short or long-term capital loss, but the benefits are limited.


How to Know Which Options to Exercise

It’s generally advantageous to exercise deep-in-the-money options that are nearing expiration.


Deep-in-the-money options have a larger bargain element, which creates a higher tax bill, but the additional tax is usually worth the reduced risk that you’ll buy and pay tax on shares without generating a profit.


It’s simple in theory, but reality is rarely this straightforward.


The decision of which option(s) to exercise and when to exercise them must be made by analyzing your specific option inventory, tax situation, and many other personal factors.


Should You Sell or Hold After Exercise?

Again, this decision must be made according to your personal and financial circumstances.

A few things you should consider:


1. Remaining tax liability

2. Concentration risk

3. Financial Goal Attainment


Tax Liability from Stock Options

Equity recipients typically receive a high salary in conjunction with their equity benefits. This increases the likelihood that taxes on equity income are withheld at 22% but taxed at or between a 32% to 37% marginal tax rate.


If this is the case, there could be a substantial liability at tax filing the following year. It’s crucial to work with professionals to help determine your tax liability and ensure you have cash available to cover it.


Employer Stock Concentration Risk

Holding most of your net worth in company stock and options is the equivalent of putting all your eggs in one basket.


On paper, your wealth can skyrocket, but your primary income source, health insurance/benefits, and the majority of your wealth could be wiped out in the blink of an eye.


It’s okay to hold a portion of company stock, but you should always be aware of the total value of your company stock holdings in relation to the rest of your investment assets.


Using Stock Options to Attain Your Financial Goals

It can be tempting to accumulate a concentration of employer stock and picture your lifestyle in scenarios where the price doubles, triples, and quadruples.


However, a better approach is:


  • Crafting a clear vision of the future you and your family desire

  • Determining what amount of wealth would make that life a reality

  • Creating a plan to achieve that life by identifying exercise/sell price points for your company stock.


Conclusion

Company stock options give you the opportunity to capture all the upside of your employer stock without taking on any downside. However, a lack of understanding can lead to adverse outcomes.


At best, you may pay more tax than you should have. At worst, you could lose your primary source of income, the majority of your net worth, and be left with a tax liability you can’t afford.


Disclaimer

Unrivaled Wealth Management (“UWM”) is a registered investment advisor offering advisory services in the States of Pennsylvania, Ohio, and in other jurisdictions where exempted. Registration does not imply a certain level of skill or training.


This communication is for informational purposes only and is not intended as tax, accounting or legal advice, as an offer or solicitation of an offer to buy or sell, or as an endorsement of any company, security, fund, or other securities or non-securities offering. This communication should not be relied upon as the sole factor in an investment making decision. Past performance is no indication of future results. Investment in securities involves significant risk and has the potential for partial or complete loss of funds invested. It should not be assumed that any recommendations made will be profitable or equal the performance noted in this publication.


The information herein is provided “AS IS” and without warranties of any kind either express or implied. To the fullest extent permissible pursuant to applicable laws, Unrivaled Wealth Management, LLC (referred to as “UWM”) disclaims all warranties, express or implied, including, but not limited to, implied warranties of merchantability, non-infringement, and suitability for a particular purpose.


All opinions and estimates constitute UWM’s judgement as of the date of this communication and are subject to change without notice. UWM does not warrant that the information will be free from error. The information should not be relied upon for purposes of transacting securities or other investments. Your use of the information is at your sole risk. Under no circumstances shall UWM be liable for any direct, indirect, special or consequential damages that result from the use of, or the inability to use, the information provided herein, even if UWM or a UWM authorized representative has been advised of the possibility of such damages. Information contained herein should not be considered a solicitation to buy, an offer to sell, or a recommendation of any security in any jurisdiction where such offer, solicitation, or recommendation would be unlawful or unauthorized




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