Nonqualified Versus Qualified Stock Options

Depending upon the tax treatment of stock options, they can be classified into qualified and non-qualified stock options. Qualified stock options are also called Incentive Stock Options (ISO).

Profits from the exercise of Qualified stock options (QSO) are taxed at the capital gains tax rate (typically 15%), which is lower than the rate at which ordinary income is taxed. And to receive preferential capital gain treatment, option holders must retain the stock at least two years after receiving the option and one year after exercising it.

Gain from non-qualified stock options (NQSO) is considered ordinary income and therefore taxed at a higher rate. NQSOs may have higher taxes but they also afford a lot more flexibility in terms of whom they can be granted to and how they may be exercised. Companies typically prefer to grant non-qualified stock options because they can deduct the cost incurred for NQSOs as an operating expense sooner.

Stock Option Types

Nonqualified: Employees generally don’t owe tax when these options are granted. When exercising, tax is paid on the difference between the exercise price and the stock’s market value. They may be transferable.

Qualified or Incentive: For employees, these options may qualify for special tax treatment on gains. Tax is deferred until they sell the stock. However, the income is considered a “preference item” for calculating the alternative minimum tax.

On the other hand, nonqualified stock options come with few strings attached. Your firm simply grants the options at a fixed exercise price to a select group of employees. As the employees exercise the options, the company claims a tax deduction for the difference between the fair market value and the exercise price. Of course, this amount is also taxable to the employees.

Best of all, the company isn’t burdened with the restrictions that can plague incentive stock options. For example, with an incentive stock option, the exercise price cannot be lower than the fair market value of the stock when the option is issued. There is no such restriction on nonqualified options.

It isn’t a slam-dunk by any means, but your tax adviser can help you compare the differences between nonqualified options and incentive stock options. You may be surprised at the result.

About Scale Finance

Scale Finance LLC (www.scalefinance.com) provides contract CFO services, Controller solutions, and support in raising capital, or executing M&A transactions, to entrepreneurial companies. The firm specializes in cost-effective financial reporting, budgeting & forecasting, implementing controls, complex modeling, business valuations, and other financial management, and provides strategic help for companies raising growth capital or considering M&A/recapitalization opportunities. Most of the firm’s clients are growing technology, healthcare, business services, consumer, and industrial companies at various stages of development from start-up to tens of millions in annual revenue. Scale Finance LLC has offices throughout the southeast including Charlotte, Raleigh/Durham, Greensboro, Wilmington, Washington D.C. and South Florida with a team of more than 40 professionals serving more than 100 companies throughout the region.