Definition of Non-Qualified Stock Options
Non-Qualified Stock options are a type of compensation to the employees where the employees are provided with the right to acquire the shares of the company at a predetermined price in the future when the options vest, but if the employee left the organization before the options are vested, the options have lapsed, and differences between the market price on the exercise date and the actual exercised price are taxed at a normal income tax rate.
Explanation
Non Qualified stock options are the type of incentives provided to the employees where they benefit from the increasing value of the company’s shares. In these options, employees have the right to purchase the shares at a later date at a predetermined price, and income tax is required to be paid on the difference (the market price of the share on the date of exercise of option – the price at which option is exercised)at the normal tax rate. It is how a company can minimize the compensation that it has to pay to the employees in cash.
Features of Non-Qualified Stock Options
- It is a type of non-cash compensation to employees.
- Tax is paid on the difference of the market price of the share on the date of exercise of the option and the predetermined price at the normal tax rate.
- The agreed price is equal to the market price of shares available at the grant date.
How does it Work?
To encourage the employee of the company for their work, they are provided with compensation in the form of rights to acquire the shares of the company in the future at an agreed price. This predetermined price is equal to the market price at which the shares are available on the grant date. Three terms should be known to the employees when these options are provided to the employees that are Grant date, Date of Vesting, and Date of Exercising the option. The grant date is the date on which rights are granted to the employees to acquire the shares of a company at a predetermined price. The vesting date is the date from which the employee can opt for the option.
Before this date, employees cannot opt for the option, and after the expiry of the vesting period, options have lapsed. The exercise date is when employees execute their right and purchase the shares at an agreed price. Generally, these options are available to the employees at a discount as the prices of shares increase over the time, and they acquire the shares at an agreed price on the grant date. The spread that is the difference between the market price on the date of opting for the option and the Agreed price is added to the normal income of the employee and taxed at the normal tax rate.
Example of Non-Qualified Stock Options
Suppose Zee Ltd. provide their employees with unqualified stock options to acquire 2000 shares after one year for three years at an agreed price of $50 per share. It means the employees cannot opt for the option right now. They have to work till one year for opting the option. After one year, they can purchase the shares of the company at an agreed price of $50 per share instead of the market price of the share on the exercise date (Assuming $60 per share). But this option is available to them for three years from the vesting date. After the expiration of this period, their options will lapse. The difference of $10 (S60 – $50) per exercised share is added to the normal income of the employee and taxed accordingly.
Tax Treatment for Non-Qualified Stock Option
The difference between the market price of the share on the date of exercise of the option and the price at which the option is exercised is added to the taxable income of employee even if these shares are not sold by the employees immediately where this difference is taxable at a normal slab rate of income tax applicable on the employee. There is no tax treatment at the time of granting the option and on the vesting date. Tax treatment is only done at the time of exercising the option by the employee before the expiration of the vesting period.
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Suppose, in the above example, an employee exercise 20% of its right after the vesting date. So, on the date of exercising the option the employee has to pay $ 20,000 [(2,000 shares*20%)*50] instead of $24,000 [(2,000 shares*20%)*60].If, after exercising the options, an employee sells the shares immediately, he would have a short term capital gain of $4,000. The difference between the market price of the share on the date of exercise of the option ($24,000) and the price at which the option is exercised ($20,000) is to be added to the taxable income of employee even if these shares are not sold by the employees immediately where this difference is taxable at normal slab rate of income tax applicable on the employee.
How to Use Non-Qualified Stock Option
These stock options plans can impact the financial situation of the employee in many ways. Generally, the employees acquire the shares at an agreed price after the vesting date, and this spread is added to the taxable income of the employee and sell off the shares after few years when the share price rises and become eligible for capital gain treatment, but this is not possible the case at all the time. Suppose Miss Leena exercises her share at $40 per share when the market price is $60 per share and pays taxes on the spread of $20 per share. She held these shares and decided to sell off after a few years when the price rises. But the price reduces to $50 per share in the next three years. If Miss Leena had waited to opt for his share, she would have paid the taxes on the spread of $10 per share only. But it is quite impossible to predict the share price correctly.
Qualified vs Non-Qualified Stock Option
The stock options are classified into qualified and non-qualified on the basis of their tax treatment. Earnings from opting for a qualified stock option are taxed at a rate lower than the normal income tax rate, that is, capital gain tax rate, whereas earnings from opting for non-qualified stock options are treated as normal income and taxed at a normal slab rate of income tax.
Benefits of Non-Qualified Stock Option
Some of the benefits are:
- By providing the non-qualified stock options to employees, it minimizes the compensation which is to be paid by the company in cash.
- The earnings (the market price of the share on the date of exercise of option – the price at which option is exercised), which is to be reported by an employee as the company shows his normal income as its operating expenses as the cost incurred for providing non-qualified stock options to an employee.
- Employees can defer the tax implication by deferring the exercise date (before the expiration of the vesting period) or sell the shares at a later date when it is more beneficial for the employee.
Conclusion
Thus, to elevate the confidence of employees, an incentive is provided to the employee in the form of the right to acquire the share of the company at a later date at an agreed price. These stock option plans are of two types based on their tax treatment: a qualified and Non-Qualified Stock option plan. The difference between the market price of the share on the date of exercise of the option and the price at which the option is exercised is added to the normal taxable income of an employee in case of non-qualified stock options. The rate of taxes is higher in Non Qualified stock option than a qualified stock option plan.
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