Definition

Qualified Stock Options

What is Qualified Stock Option (QSO)?

A qualified stock option, also known as employee stock options, is a share option given exclusively to a company's employees.  Employees can exercise these options at a pre-specified strike price, unlike their fair market value. The strike is set at a beneficial price, making these tax incentivised stock options. The special tax treatment makes them 'qualified' stock options. Employees can exercise the option up till a pre-specified termination date.

Summary
  • Qualified stock options are a type of share option given to employees at a pre-specified strike rate.
  • The strike is set at a beneficial price, making these tax incentivised stock options or 'qualified' for the beneficial tax treatment.
  • They do have favourable tax treatment. However, involve a more extended holding period.

Frequently Asked Questions (FAQ)

How does a qualified stock option (QSO) work?

Stock options are given to employees as a part of their pay package. It is a type of alternative compensation offered to only a few employees. It gives them a sense of ownership while giving them tax and share ownerships benefits.

In the case of qualified stock options, an employee receives a tax benefit when the option is exercised, and an individual employee doesn't have to pay ordinary income tax. Instead, he is only taxed on the difference between the strike price and the fair market value of issued shares.

The taxation category application is dependent on the timeshares held for. When employee holds the shares for a year from exercise date or two years from the option grant date, they may get charged with a long-term capital gains tax. Such a tax is often lower than the prevailing income tax rate they would have paid on his cash salary. It makes the qualified stock options incentivised for employees.

Qualified stock options are offered with a pre-set strike price at or above the stock's market price on the date of issue. However, qualified stock options are not exercisable until several years in future and often expire after specific years of issuance or upon termination.

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Example

Consider that shares of Magic Ltd are trading on ASX at AU$15. Now Magic Ltd launches an incentive scheme to reward employee efforts to grow a company. On the increase in the share price, qualified stock options are given with an AU$20 strike price exercisable after ten years. So, for example, if Magic Ltd.'s stock price is AU$25 after ten years, each of its rewarded employees holding qualified stock options can make a profit of AU$5 on choosing to exercise the option. Now, if an employee Z comes in a 30% income tax bracket, he will not precisely pay 30% on this gain. Instead, he will have to pay tax at the long-term capital gains rate, usually a lower tax bracket.

It is clear that qualified stock options do have favourable tax treatment; however, it involves a more extended holding period. A longer holding period makes it possible for the employees to benefit from the optimal tax treatment. However, an increased holding period does have an increased risk on the option price.

Qualified option holders may not exactly have to pay tax on the exercise date. However, the amount of the bargain element may attract an alternative minimum tax (AMT). Also, if these options are sold, they attract tax on the sale. However, there is a catch here, if options are sold as soon as exercise, the bargain element may get treated as regular income for the holders. Otherwise, if employees hold the stock for at least one year after exercising or don't sell them for at least two years from the option grant date, these will be taxed for long term gains at lower rates.

What makes employee stock options qualified?

An employee stock option must fulfil the following conditions to qualify for the special tax treatment.

  • Qualifying stock options cannot be granted to someone who owns over 10% of existing classes of issued shares. It is only possible if certain legal conditions are specified.
  • Only employees are eligible for qualified stock options.
  • There is capping for the maximum aggregate fair market value of shares bought through a qualified stock option in a calendar year.
  • For being termed as a qualified stock option, they must be held for a pre-specified minimum period.
  • Qualified stock options are not transferable by the recipient employee.

What is the difference between qualified and non-qualified stock options?

The significant difference is based on the tax treatment, making qualified stock options unique from non-qualified stock options.

  • Gains from the qualified stock option (QSO) exercise are taxed at the prevailing rate for capital gains. Most capital gain taxes are lower than the tax rate for ordinary income or salary income. To receive this special tax treatment at a lower rate, option holders must hold the stock for a minimum period after receiving the option and even after exercising it. For employees, tax payment gets deferred until they sell the stock. Income from stock sale gets considered for alternate tax calculation.

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  • On the flip side, gain from non-qualified stock options (NQSO), which is the exact opposite, are taken as ordinary income. Due to this, the tax treatment is like regular income, at a higher rate. NQSOs, though they get taxed at a higher rate, do offer more flexibility. Companies have the freedom to decide to whom these can be granted or how they will exercise them. At grant date, these don't generally have tax implications on the employees. The difference between the exercise price and the stock's market value gets taxed only when exercising these rights. These are also transferable.

Corporations grant stock options only to a few deserving employees, that to a fixed exercise price. When employees exercise the options, the employer organisation claims a tax deduction for the difference between the fair market value and the exercise price. However, the amount is taxable to the employees.

In the case of a qualified stock option, the exercise price cannot be lower than the fair market value at the time of issue. Non-qualified options do not have any such restrictions.