NSOs

What You Need to Know About NSOs

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The opportunity to have ownership in something can bring with it a sense of pride and responsibility. It’s one of the reasons why many people look forward to buying their first home after renting an apartment, or why that book at the library may have a little more wear and tear than the same version carefully displayed on someone’s shelf. As employers look for other ways to incentivize and reward their employees, stock options are one such benefit that should be considered and understood.   

Non-statutory Stock Options, or NSOs – also known as non-qualified options – can be offered to everyone from the everyday employee to 1099 contractors and allow them to participate in the growth and ownership of the company. The cost of exercising an NSO is determined by the initial price granted multiplied by the number of shares exercised. 

What Does it Cost?

Before exercising an option, it’s always good to remember that stock options are the option and not the obligation to purchase a company’s stock. Employees who are given these options do not have to take part in the offering, although many times they may have a financial incentive to do so.

When exercising an option, there are two costs to consider: the cost of exercising the option and the associated tax that comes with it. The cost of the option is equal to the “strike price of the option multiplied by the number of options exercised. Taxes upon exercise are calculated based on the “bargain element,” or the difference between the strike price and what the shares are valued at on the day of exercise. For NSOs, taxes on the bargain element are added to your W2 and then taxed as ordinary income.  

  • Cost to Exercise = Cost of Option + Taxes on Exercise
  • Cost of Option  = Strike Price * # of Options Exercised 
  • Taxes on Exercise = (FMV – Strike Price) * # of Options Exercised

For first-time NSO-exercisers, it’s important that you understand how this could affect your tax bill. Individuals who look forward to getting a tax refund could be due an unwelcome surprise if they hadn’t considered that they would owe more in taxes or if their employer hadn’t withheld anything from their paychecks upon exercise of the NSOs. 

How Much to Exercise?

The amount you exercise in an NSO purchase may largely be a financial decision. Is the current share price higher than the strike price of your option? Do you have the funds necessary to exercise? Will you owe additional taxes? 

While some individuals have saved up the funds required for their exercise, others may require more creative ways of financing. Short-term loans may be available through banks, financial institutions or the employer. Employers may allow for loan provisions within the 401(k), or the client’s custodian might offer lending on other assets via a securities-backed loan.

Others may decide to exercise NSOs in a call-to-cover strategy – a term used to describe simultaneously exercising an option and then selling the underlying stock to pay for the tax. While this may be appealing because it results in no out-of-pocket cash, employees may be losing out on the future growth compared to if they had not sold and instead held onto the stock. 

NSOs Exercised, Now What?

Once you’ve exercised your NSOs, congratulations! You are now among the proud ownership collective within your company. The health and potential growth of the company combined with your financial situation will likely determine how long you decide to hold onto your shares.

Short-term vs. long-term Capital gains? Is there a potential merger with a larger company? Do you have the ability or desire to hold company stock after you leave the company? Is step-up in basis something that’s important to you? These are just a few questions you should consider when deciding what to do with your newfound ownership.

NSOs in Action

Let’s look at a hypothetical “real world” example of NSOs: Prakash was granted 1,000 NSOs at $1 each. The NSOs came with a three-year vesting schedule, prohibiting his ability to fully exercise the NSOs until his third work anniversary. Should he decide not to utilize the NSOs, they also had a seven-year expiration date, at which point his NSOs would no longer be usable.

On Prakash’s fifth work anniversary, his company stock was valued at $6 per share. Believing that the company stock would keep increasing, Prakash exercised all 1,000 options at the original cost of $1 per share. As a result, he added $5,000 in taxable ordinary income – calculated by subtracting the current price ($6) and the original price ($1), multiplied by the number of options (1,000).

The tax generated from Prakash’s NSO exercise is counted as income. As his household’s income through combined wage incomes was $80,000, his total projected income will be $85,000 ($80,000 + $5,000).

Now that he has exercised his options, Prakash can sell his positions at any time. Selling within 12 months will yield the most inefficient tax strategy, as short-term capital gains are treated similarly to ordinary income and taxed up to the highest marginal bracket of 37%.

Waiting to sell for at least 12 months plus one day would provide Prakash a preferential tax break, given that the maximum tax rate for long-term capital gains is 20% (not including the additional 3.8% Net Investment Income Tax).

When the company holds its IPO the following year, Prakash is pleased to discover his stock is now worth $13.50 per share. Wanting to further his financial goals and pay down his wife’s student loans while also still taking advantage of the company’s future growth potential, Prakash decides to sell half of his equity position.

Prakash’s current equity position is $13,500 ($13.50 per share x 1,000 shares), while his realized equity position is $6,750 ($13.50 per share x 500 shares). His taxes due upon sale come to $3,750 – take the current share price ($13.50) minus the share price when Prakash exercised his options ($6) and multiply by the number of shares sold (500).

This example does not reflect sales charges or other expenses that may be required for some investments. Rates of return will vary over time, particularly for long term investments.

This blog is not intended to provide specific legal, tax, or other professional advice. For a comprehensive review of your personal situation, always consult with a tax or legal advisor.

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