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Date:   Thu, 2 Sep 1999
From:   Michael

What is a Non-qualified Stock Option Plan? General information. What is it? How does it work generally?

Answer

Date:   Sat, 04 Sep 1999

Hello Michael,

Thanks for writing your question.

A non-qualified stock option is a way for a company to compensate employees or service providers without paying cash.

Instead, the company grants the employee or service provider an option to purchase shares of stock at a fixed price. The price is about the amount the stock is trading for when the stock is publicly traded. When the stock isn't publicly traded, the company determines the value of a share of stock on the date the option is granted. The option typically lapses on a certain date.

The incentive to the employee or service provider is to participate in the potential increase in value of the stock without having to risk a cash investment.

Since this arrangement is a form of compensation, the employee or service provider generally must report ordinary income when the option is exercised. The amount of ordinary income is the excess of the fair market value of the shares received over the option price.

The company receives a tax deduction for this ordinary income element reported by the employee or service provider.

The reason these options are called "non-qualified" is they do not qualify for special treatment of another type of option, called "incentive stock options."

Incentive stock options are only available for employees and other restrictions apply for them. For regular tax purposes, incentive stock options have the advantage that no income is reported when the option is exercised and, if certain requirements are met, the entire gain when the stock is sold is taxed as long-term capital gains.

Good luck!

Mike Gray

For more information about non-qualified stock options, request our free report, Non-Qualified Stock Options - Executive Tax and Financial Planning Strategies.

IRS Circular 230 Disclosure: As required by U.S. Treasury Regulations, you are hereby advised that any written tax advice contained in this answer was not written or intended to be used (and cannot be used) by any taxpayer for the purpose of avoiding penalties that may be imposed under the U.S. Internal Revenue Code.