Non-Qualifying Stock Options – Equity Compensation at Private Firms

Next in our Equity blog series we will take a look at Non-Qualifying Stock Options (NSOs).

Don’t let the name “non-qualifying” confuse you. “Non-qualifying” simply means that this type of stock option does not qualify for special treatment the same way incentive stock options are treated. You can also think about “non-qualifying” stock options as “regular” stock options.

Let’s look at an example

Let’s say Jill joins XYZ Company in June 2018 and is given a non-qualifying stock option for 1,000 shares at a grant/exercise/strike price of $5. For simplicity sake, we’ll say that shares will vest at 25% per year:

June 2018: Stock option granted
June 2019: 250 shares vested
June 2020: 250 shares vested
June 2021: 250 shares vested
June 2022: 250 shares vested

In June 2022, all 1,000 shares of XYZ Company’s stock have vested. Jill decides to exercise her option to buy all 1,000 shares at her grant price of $5 per share when the value of XYZ Company’s stock is $50 per share.

Jill writes her company a check for $5,000 (1,000 shares x $5 per share), and the company in returns gives Jill 1,000 shares of stock. Jill is now officially a stockholder.

How NSOs are taxed

Jill paid $5 per share for a stock that is valued at $50 per share. This $45 difference is considered income to Jill and is included on her Form W-2:

1,000 shares x $45 difference between grant price ($5) and fair market value ($50) = $45,000 included on Jill’s Form W-2

Sale of NSO Stock

If the stock is held for one year or longer past the exercise date, long-term capital gains tax rates apply. Otherwise any gain is considered ordinary income.

Talk to your employees

There is of course a tax on this “paper” income. It’s important that you inform your employees to prepare for this additional tax, so they are not caught off guard when the taxman comes calling.

Next: Incentive Stock Options

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Post by Curt Mastio
Jul 17, 2020 9:04:35 AM

Curt Mastio started Founder’s CPA in 2017 and currently serves as the Managing Partner of the firm. After obtaining both his Bachelor’s and Master’s degrees in accounting from the University of Illinois in Urbana-Champaign Curt started his career in Big Four public accounting. Shortly thereafter Curt served as the Chief Financial Officer of Storage Squad began his stint as an Adjunct Instructor at Northwestern University’s Farley Center for Entrepreneurship and has been teaching Accounting & Finance to undergraduate students for 6+ years. In his current role Curt oversees strategy, operations, and business development at Founder’s CPA. Further, Curt has experience working directly with 200+ startups and small businesses providing accounting, tax, and outsourced CFO services. His industry expertise lies in the SaaS, Blockchain, Marketplace, and Fintech industries. He has served as a key advisor working directly with startups that range from pre-revenue to companies generating over $30 million dollars a year in revenue. Lastly, he serves a key role working directly with the firm’s clients that have collectively raised over $200 million in venture capital funding to date. Curt is also an active advisor, mentor, and investor in the startup ecosystem. He has facilitated numerous workshops, webinars, and presentations to incubators and other startup-centric organizations. He is also an active mentor for Techstars in both Chicago and Iowa. Outside of his daily professional duties Curt is actively involved with Beat the Streets Chicago and was a founding member of its Young Professionals Board. His efforts in both leadership and community involvement were recognized when he was awarded the Illinois CPA Society’s Outstanding Young Professional Leadership Award in 2020. He was also a panelist at their annual conference in 2022 where he spoke about his experiences starting and operating a public accounting firm. He maintains an active Certified Public Accountant designation that he obtained in 2014. Outside of work, Curt can be found spending time with his friends & family including his dog Rufus. His hobbies include golf, boating, cooking, reading, and attending sporting events & concerts.