Definition of Nonstatutory Stock Options
Stock options allow publicly traded companies to improve employee compensation packages without increasing monthly payroll expenses. The Internal Revenue Service (IRS) recognizes two types of employer-issued stock options: statutory and nonstatutory. While nonstatutory stock options (NSOs) lack the employee tax benefits of statutory ones, the former yield several benefits for employers.
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History
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Although options contracts have been in existence for hundreds of years, their use as a form of employee compensation didn't really come into vogue until the mid-20th century. In 1949, any personal income that fell into the top tax bracket was subjected to a 91 percent tax. Then, in 1950, United States legislators passed a law that allowed profits from employee stock options to be taxed at the capital gains tax rate of 25 percent. As a result, many companies began substituting their top executives' salaries with stock options, taking advantage of this newly created tax haven. By the late 1950s, companies competing for talented employees even started offering stock options to nonexecutives.
Congress did away with this tax-haven status in 1976. However, the Economic Recovery Tax Act of 1981 created two types of stock options --- incentive stock options (ISOs) and nonstatutory stock options (NSOs) --- which allowed employers to choose where the tax liability for exercising the options would ultimately lie.
Mechanism
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When issued to an employee, nonstatutory stock options give him the right --- but not the obligation --- to buy a specific number of shares in the company at a specific price known as the "strike" price. This amount is equal to the market value of the stock at the time of issuance. If the holder chooses to "exercise" the NSO, his stockbroker buys the specified number of shares from his company at the strike price. If the market price is higher than the strike price, the holder can either immediately sell these shares on the open market at a profit or save them for a later date.
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Who's Allowed to Hold Them
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Unlike statutory or "incentive" stock options (ISOs), nonstatutory options can be issued to employees as well as to outside service providers. These outside providers include lawyers, suppliers, vendors and consultants. Once issued, NSOs cannot be sold or transferred. Recipients must either exercise the NSO or simply allow it to expire.
Employer Benefits
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When an employee stock option is exercised, the company must produce shares for the holder. To obtain them, the company can either buy existing shares from the open market or issue new ones.
If the company buys the shares at the higher open market price and sells them to the holder at the lower strike price, it loses money on the transaction. However, the company is allowed to claim any losses from exercising NSOs as a tax deduction. This tax benefit is unique to NSOs: Companies aren't allowed to claim losses from exercising ISOs on their taxes.
By purchasing existing shares, a company can also avoid a problem known as "dilution." Issuing new shares increases the total number of shares outstanding. This increase adversely affects key financial metrics such as earnings per share (EPS), return on equity (ROE) and P/E ratio. This can ultimately result in a depressed stock price.
Tax Issues
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If a holder receives profits from exercising her nonstatutory stock options, she must report it as capital gains to the IRS. The IRS defines "short-term" capital gains as profits made on the sale of an asset that was owned for less than one year. Thus, if the holder immediately sells her shares at a profit, the proceeds from exercising her NSO will be taxed as a short-term capital gain.
However, if the holder simply keeps the shares in her portfolio and doesn't sell them, she still has to pay a short-term capital gains tax rate on the money her company lost when she exercised the NSO. Basically, because the company's loss --- buying the shares from the market and selling them to the NSO holder --- occurred in a matter of seconds, the resulting "gain" in value for the holder is viewed by the IRS as a short-term capital gain.
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