Non-Qualified Stock Options (NQSOs) are a form of equity compensation that can be offered by an employer. NQSOs provide an opportunity for employees to participate in the company’s appreciation over time. Deciding whether to exercise NQSOs and the timeline for subsequently selling shares can be stressful. With the proper strategy for cash flow and tax planning, owning NQSOs can be a huge benefit to your overall financial plan.
NQSO Issues to Consider at Grant
Although many people are concerned about the timeline for exercising NQSOs and selling shares, there are actually a few details to consider at the grant date. The “grant date” is the date that your employer delivers you your NQSOs.
As with all stock options, it is important to determine if your NQSOs are subject to a vesting schedule. If so, your options may vest over time or upon a specific performance goal being hit. It is important to monitor all timelines and dates as they relate to your vesting schedule so that you can make informed decisions about when to exercise your shares.
Often, income tax is not due in the year that you are granted your NQSOs. However, there can be exceptions if the value of your option is readily ascertainable or if the option price is discounted. Typically, the value of an option is considered to be readily ascertainable if it is traded on a securities exchange. If your NQSOs fall into one of these categories, taxes may be owed at the time they are granted to you.
Exercising your NQSOs
There are several factors to consider prior to making the decision to exercise your NQSOs. Market value, tax implications and cash flow analysis can all have an impact on the recommended timing for exercising your options.
It is essential to compare the exercise price of your options with the stock’s current fair market value. If the fair market value of the stock exceeds the exercise price, your options are considered “in the money”. This difference is also known as the potential bargain element. In other words, when it comes time to sell your shares down the road there is the potential for a gain on the sale.
When it comes to NQSOs there are several income tax implications to consider at the time of exercise. When you exercise your NQSOs, ordinary income tax and payroll tax will be due on the bargain element in the year you exercise. As a reminder, the bargain element is amount by which the fair market value exceeds the exercise price of your shares. In some cases, employees may qualify for the IRC §83(i) election. This election allows employees to defer income tax for up to five years.
Depending on the specifics of your NQSO plan, you may have the option to exercise early and purchase stock prior to your options vesting. If you have this option, there are additional tax implications to consider. Typically, in this situation, ordinary income tax and payroll tax will be due on the bargain element in the year of vesting. As the tax implication occurs at the time of vesting, ordinary income tax will not be due at exercise. If you choose to exercise early, you may have the option to make an IRC §83(b) election. This election allows you to accelerate the recognition of ordinary income tax to the year of early exercise. This election also starts the capital gain holding period and any future appreciation would be taxed as a capital gain.
Sale of Stock Issues to Consider
There is special timing to take into consideration when it comes time to make decisions about selling your shares of stock. It is typically recommended to wait one year after the exercise date to sell your shares of stock. When you sell the shares more than one year after the exercise date, you will recognize long-term capital gains or losses. If you sell your shares within one year of exercising, you will recognize short-term capital gains or losses which can be less preferential from a tax perspective.
If you chose to exercise your shares early, your holding period begins when your stock vests. However, if you chose to make an IRC §83(b) election, the holding period starts the day after the stock is transferred.
Some companies have specific rules for trading your shares of stock. Consider whether your company has any blackout periods where you are not allowed to trade your stock. Also confirm whether you need preclearance to sell your shares. Understanding these limitations or requirements will allow you to be best prepared for making decisions about when it is most beneficial to sell your shares.
NQSOs can be a terrific employment benefit and when properly factored into your financial plan can assist in meeting your future financial goals. Check out the checklist below to make sure you understand all of your options when it comes to maximizing the benefit of your NQSOs. If you would like to discuss how to effectively integrate an exercise and sale strategy that coordinates with your specific goals, please schedule a meeting here.
Pearl Planning does not provide legal or tax advice. The information herein is general and educational in nature and should not be considered legal or tax advice. Tax laws and regulations are complex and subject to change, which can materially impact investment results. Pearl Planning cannot guarantee that the information herein is accurate, complete, or timely. Pearl Planning makes no warranties with regard to such information or results obtained by its use, and disclaims any liability arising out of your use of, or any tax position taken in reliance on, such information. Consult an attorney or tax professional regarding your specific situation.
Melissa Joy, CFP®, CDFA® is President and Wealth Advisor at Pearl Planning. Reach out for a call today at 734.274.6744.