Nonqualified

Lesson

Nonqualified employee stock options (NQSOs) are a type of equity compensation that companies can offer to their employees. Unlike incentive stock options (ISOs), NQSOs do not receive preferential tax treatment and are subject to ordinary income tax rates upon exercise. However, they are more flexible and can be granted to a broader range of employees, including non-employees such as consultants and board members.

Practice Question #1

Which of the following is NOT a characteristic of nonqualified stock options?

A) Preferential tax treatment

B) Can be granted to non-employees

C) Subject to ordinary income tax rates upon exercise

D) More flexible than incentive stock options

Select an option above to see an explanation here.

A) Nonqualified stock options do not receive preferential tax treatment. B) Nonqualified stock options can be granted to non-employees, such as consultants and board members. C) Nonqualified stock options are subject to ordinary income tax rates upon exercise. D) Nonqualified stock options are more flexible than incentive stock options.

Terms

Nonqualified Stock Options (NQSOs):: An employee stock option that does not receive preferential tax treatment.
Exercise:: Purchasing the underlying stock at the option's strike price.
Strike Price:: The predetermined price at which the option holder can purchase the underlying stock.
Vesting:: The process by which an employee becomes eligible to exercise their stock options.
Expiration Date:: The date by which the option holder must exercise their options or they will expire.
Ordinary Income:: Income that is subject to regular income tax rates.
Capital Gains:: The profit made from the sale of an asset, such as stock, which is subject to capital gains tax rates.
Grant Date:: The date the stock options are granted to the employee.
Bargain Element:: The difference between the stock's market price and the option's strike price at the time of exercise.

Practice Question #2

What is the bargain element in a nonqualified stock option transaction?

A) The difference between the grant date and the exercise date

B) The difference between the strike price and the market price at the time of exercise

C) The difference between the market price at the time of exercise and the market price at the time of sale

D) The difference between the strike price and the grant date

Select an option above to see an explanation here.

A) The bargain element is unrelated to the grant or exercise dates. B) The bargain element is the difference between the strike and market prices at the time of exercise. C) The bargain element is unrelated to the market price at the time of sale. D) The bargain element is not related to the grant date.

Do Not Confuse With

Incentive Stock Options (ISOs):: An employee stock option that receives preferential tax treatment but has more restrictions on eligibility and exercise.

Practice Question #3

Which type of employee stock option receives preferential tax treatment?

A) Nonqualified stock options

B) Incentive stock options

C) Restricted stock units

D) Stock appreciation rights

Select an option above to see an explanation here.

A) Nonqualified stock options do not receive preferential tax treatment. B) Incentive stock options receive preferential tax treatment. C) Restricted stock units are not an employee stock option and do not receive preferential tax treatment. D) Stock appreciation rights are not an employee stock option and do not receive preferential tax treatment.

Historical Example

In the late 1990s, many technology companies used nonqualified stock options to attract and retain talent. This led to a significant increase in the number of employees exercising their options and realizing substantial gains, which contributed to the growth of the tech bubble. Many employees were left with worthless stock options and large tax bills when the bubble burst.