What is a Nonqualified Option (NQO)?
A nonqualified option (NQO) is the right but not the obligation to purchase shares of a company, usually the option holder's employer, for a fixed price by a certain date.
How Does a Nonqualified Option (NQO) Work?
Option grants are incentive compensation that encourages employees to focus on doing work that increases the stock price and thus shareholder value, which is the primary objective of all businesses. A company's board of directors normally must approve option grants. The value of these options is derived from the price of the employer's stock.
Let's say you work for Company XYZ, and the company grants you options to buy 1,000 shares for $40 a share in the next 10 years. If Company XYZ shares rise to $60 and you have the right to buy shares for $40, you could exercise your options, pay $40,000 for your shares ($40 x 1,000), and turn right around and sell them in the open market for $60,000. You'd make $20,000 of easy money. However, note that the stock options are only valuable if the stock is trading above $40 per share before the options expire. Usually, companies grant options with strike prices above the current market price.
Why Does a Nonqualified Option (NQO) Matter?
There are two primary kinds of employee stock options: nonqualified options (NQOs) and incentive stock options (ISOs).
Holders of NQOs pay ordinary income tax on the difference between the exercise price and the market value of the stock when they exercise. So, let's say that three years after your 1,000-option grant, Company XYZ stock is up to $60. You decide to exercise even though only 600 of your options are vested. You think the stock is going to continue to increase, so you hold onto the shares.
Even though you haven't sold the shares, you have to pay ordinary income tax on the difference between the exercise price and the market value at the time of exercise. In our example, that difference would be 600 shares x ($60 - $40) = $12,000. If you're in the 28% tax bracket, that means you'll pay $3,360 even though you haven't sold the shares yet. And watch out -- you'll pay capital gains tax if you eventually sell the shares for more than $60.