Non-qualified stock options or NSOs are a type of employee stock option giving an employee the right to purchase company stock at a certain price.
What are Non-Qualified Stock Options (NSOs)?
A NSO is a type of employee stock option that gives an employee the right to purchase company stock at a certain price called the strike price. NSOs do not require employment and the expiration date can be extended well over 90 days, although they do not come with the same favorable tax benefits as ISOs.
How are NSOs Taxed?
NSOs are subject to ordinary income taxes based on the spread between the current FMV and the strike price of the option. As opposed to ISOs, NSO holders will pay taxes which are withheld when exercised. NSOs do have the possibility of an IRS Section 83(i) election where you can defer taxes for 5 years.
The minimum NSO exercise withholding requirement is only 22% for up to $1 million in spread value (37% if over $1 million). Many companies try to estimate the right amount but it isn’t very easy. Companies are required to withhold NSO taxes only for employees. Contractors can be given a 1099 instead, meaning they handle their own payments via quarterly estimated taxes. Regardless of whether the company withholds taxes or you make estimated payments, you will true it up to the required amount when you actually file taxes. That could result in a refund or additional taxes, such as when lottery winners are surprised that they often owe more taxes despite the mandatory withholding at the beginning. If you sell NSO shares you are also responsible for paying quarterly estimated taxes which you calculate yourself. If you don’t pay enough, there are interest penalties when you file next April. Additionally, Medicare, Social Security taxes, and Federal Unemployment Tax are charged on NSO exercises.
If NSOs are sold within a year of exercising after ordinary income tax was paid on the original exercise, short term capital gains are paid on the spread between the final sale price and the FMV at the time of exercise.The short term capital gains on the portion of the income above the FMV from the sale of NSOs can be offset by other capital losses you may have that tax year.
If you hold employee stock options or restricted shares in a private company funded by institutional venture capital, feel free to contact us at the Employee Stock Option Fund for ways to reduce stock option taxes or more information on how we can assist you. By doing so, you can not only avoid the risks associated with investing directly in a startup but possibly improve your taxes as well. For specific tax related support related to stock option exercises, please contact Scott Chou.
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