What it means
A stock option gives its holder the right, but not the obligation, to buy a set number of shares at a fixed exercise price (also called the strike price). If the share price rises above the strike price, the option becomes valuable, since the holder can buy at the lower price and keep the difference.
Companies use options to reward and retain staff, especially when cash is limited. NSOs are the more flexible type.
They can be granted to employees, directors, contractors and advisers, and there are fewer legal limits on their size and terms than for incentive stock options. This is why start-ups and listed companies both use them widely.
The tax treatment is the main difference. When an NSO is exercised, the difference between the market price on that day and the strike price, called the spread, is generally treated as ordinary income.
For employees, the employer usually has to withhold income and payroll taxes on the spread, and the company can typically claim a matching deduction. After exercise, the shares belong to the holder and the market price on the exercise date becomes their tax cost base.
Any further rise or fall before sale is treated as a capital gain or loss, depending on how long the shares are held. Tax rules differ between countries and change over time, so holders should take advice before exercising.
Timing and cash are practical issues. To exercise, the holder must pay the strike price and often has to cover the tax bill as well, which can be significant for someone whose shares cannot be sold yet.
Some plans allow cashless exercise or selling part of the shares to cover costs, but private company shares may not be easy to sell.
In practice
Real-world examples.
Example
A software start-up grants a new engineer 10,000 NSOs at $2 per share, vesting over four years. When the company is later sold at $10 per share, he exercises and sells, and the $8 spread per share is taxed as ordinary income.
Example
A listed manufacturer grants its non-executive directors NSOs as part of their pay. The directors are not employees, so the options are nonqualified, and the company reports the cost in its accounts.
Example
A consultant advising a biotech company receives NSOs in lieu of part of her fee. When she exercises, she reports the spread as income and the company withholds or reports it according to her tax status.
Formula
Calculation
Taxable spread = (Market price at exercise - Strike price) x Number of options exercised
Suppose an employee holds 5,000 NSOs with a strike price of $12, and she exercises when the market price is $30. Spread per option = $30 - $12 = $18. Taxable spread = $18 x 5,000 = $90,000. If her illustrative marginal tax rate is 30%, the tax is $90,000 x 0.30 = $27,000, and she also needs $12 x 5,000 = $60,000 to pay the strike price unless she uses a cashless exercise.Case study
Seen in the real world.
Bluefin Software is a fictional company whose employees held thousands of NSOs, all with a strike price of $5. When the share price rose to $20 after a strong product launch, many staff wanted to exercise at once. The finance team realised that the company would need to withhold tax on a large spread.
For one executive alone, the spread was ($20 - $5) x 40,000 = $600,000. The finance director arranged for the company to allow share withholding, so part of the shares would be kept to cover the tax rather than requiring the executive to pay cash.
In this illustrative story, the company also began modelling the expense, tax deductions and share dilution before each exercise window. That helped the board understand the real cost of its option plan, which is not just the accounting charge but also the dilution to other shareholders.
Watch out
Common mistakes.
- Treating the spread as capital gain. At exercise, it is normally ordinary income, and only later movements may qualify as capital gains.
- Exercising without planning for the tax bill. The tax is due on a gain that has not been turned into cash if the shares cannot be sold.
- Ignoring expiry and leaver rules. Options often lapse soon after leaving the company, so check the deadline.
Questions
People also ask.
What is the difference between an NSO and an ISO?
An incentive stock option may get special tax treatment but has stricter rules, while an NSO is more flexible and taxed as income on exercise.
Who can receive an NSO?
Employees, directors, contractors and advisers can generally all receive them.
Does the company get a tax deduction?
Generally yes, the company may deduct the amount the holder includes as income, subject to local rules.
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