Non-Qualifying Stock Options
Stock options come in several different forms, but most people only ever encounter non-qualified employee stock options. An increasing number of employees receive non-qualified employee stock options as a form of compensation from their employer. Non-qualified employee stock options can add thousands of dollars to an employee's income, but carry some extra tax considerations.
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Stock Options
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At a basic level, a stock option is a contract that gives the holder the right to buy or sell 100 shares of stock in a specific company for a specified price (usually the price of the shares the day the contract was signed, which investors call the strike price) during a specified window of time. The holder can choose whether or not to actually buy the shares, the contract simply gives the holder the option, hence the name.
Types of Stock Options
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Stock options are a kind of financial instrument known as a derivative in the finance world. There are two main types of stock options: commercial stock options, which are bought and sold on options exchanges, and employee stock options, which cannot be sold and function as a type of compensation. Employee options come in two forms: incentive stock options, which usually go to executives, and non-qualified.
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How Non-Qualified Options Work
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When an employer grants options to an employee, the employee cannot immediately use the options. The options must "vest" first, which means complete a waiting period that both makes them more valuable, assuming that the company's share prices trend upward, and helps to retain employees because they cannot use unvested options if they leave the company. Once the options vest, which can take anywhere from six months to five years, depending on the company, the employee can take the contract to a broker and buy stock at the strike price any time before the contract's expiration date.
Taxes
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The Internal Revenue Service uses different terminology; non-qualified employee stock options become non-statutory stock options and incentive options are called statutory options. The IRS taxes the difference between the strike price and the market price on the day an employee uses the options to buy shares. The IRS treats non-qualified stock options as a bonus, in other words, profit from using the options counts toward that year's income.
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