Qualified Stock Option

Categories: Derivatives, Tax

See: Non-Qualified Stock Option (NSO).

A qualified stock option usually refers to the flavor of option granted to employees at an early-stage startup company, whose treatment gets long-term capital gains treatment rather than that of the higher taxed, ordinary income rate.

In a QSO, the employee can buy out the options, own the (common) stock, pay a tax on the spread from their strike price to the latest 10b5-1 price, if there is any spread, and then hold those options a year. If they do allllll that, then they get to pay meaningfully less in taxes when they then eventually go to sell the stock after the hugely successful IPO. You want QSOs much more than you want NSOs, because the tax delta, especially in Blue States, is...big.

Related or Semi-related Video

Finance: What is a Qualified v Non-Quali...11 Views

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Finance Allah shmoop What is a qualified versus nonqualified stock

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option plan qualified for favorable long term gains tax treatment

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Thank you very much if you have qualified stock options

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a incentive stock options or ISOs as they're called around

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Silicon Valley And yes those air relatively rare They're generally

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on ly given to the very first I'ii single digit

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number of employees joining a company Then those employees get

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the benefit of being able to buy out their stock

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options and having them become fully owned Common shares on

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very favorable tax bases The ability to buy them out

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not have to pay big taxes at the time you

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do is a big benefit and well you'll see why

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not just for the meaningful vibe of being able TTO

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feel like and actually be a co owner of the

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company But because it usually means that the employees investors

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will qualify for much cheaper tax rates when they eventually

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do sell if the employees does not buy out the

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options While there's no difference in tax treatment that is

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these options are treated just like the nonqualified non stock

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options or en esos got it non stock options Gordon

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ISOs Well the number which can be granted within a

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companies E stop or Employee Stock Option Plan program are

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limited And if a company violates this number by granting

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too many qualified stock options well then the company is

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taxed heavily as it is viewed by the IRS is

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having used quote falsely cheap unquote stock to pay key

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employees Catch Aly That's called the cheap stock rule applies

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to our issues and some other things as well Well

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the granting of these kinds of compensatory stock options can

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only be given to employees slash insider's of the company

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they have to be granted at a fair market value

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strike Price III Whatever the four o nine evaluation calculated

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by lawyers and bankers and bean counters said the company

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was worth That's the valuation the strike price has to

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reflect for the the common stock meaning they get an

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appraisal from a bunch of bankers and lawyers And they

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tell you what the common stock is worth today And

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it's usually in an early stage company worth a whole

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lot less than the preferred stock because the company's odds

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of going bankrupt are really high at that point So

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these type of stock options carry a maximum life of

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ten years usually And then there are the ten percent

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rules that is for at least ten percent of the

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shareholders The exercise price of these options has to be

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ten percent greater or more than the fair market value

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of the company at the time Well because these options

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receive such favorable tax treatment there strike price has to

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carry a premium right That's that ten per cent thing

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And lastly the maximum cap or value of the stock

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options for any individual cannot exceed one hundred grand at

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least in today's world as exercised or bought out in

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any one year In other words they're designed only for

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the very early employees with companies carrying very low valuations

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E early start ups Okay so that's qualified stock options

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The other end of the world nonqualified stock options Yeah

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that's for the rest of us blue collar slobs Well

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those options can in fact also be bought out But

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upon that transaction employees are taxed as if they are

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direct compensation and those taxes are levied as ordinary income

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I either very high tax rates So in practice most

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employees getting qualified stock options by them out almost immediately

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And usually there's a negotiation before that employee has hired

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such that their commitment to the company has made clear

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by their tacit agreement to buy out their qualified options

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and have financial skin in the game For employees with

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nonqualified stock options and the buyout usually doesn't happen and

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those options are viewed as well Gentle lottery ticket potential

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big wins way down the line Should the company do

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well that's not always the case Sometimes people buy him

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out but the big tax treatment favorability eight there So

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you and your roommate both joined Shmoop flicks early You

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both received the same grant of one hundred thousand options

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at a dollar a share strike price How was this

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dollar calculated Well lawyers and bean counters were hired for

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small feet to make their own valuation assessment of the

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company And when they completed that review they determined that

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if the company were sold today it's common shares would

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command a dollar each on the open market or eBay

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or Rush Watch or Fidelity or wherever the company was

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sold That number's called the four o nine evaluation in

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the strike price of those options applies to pretty much

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all the flavors of options you know qualified or ISOs

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and nonqualified stock options Unfortunately because you only majored in

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E con your package gave you nonqualified stock options whereas

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your roommate was an engineer So she received qualified stock

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options Not a big deal of the time You didn't

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really even care notice other than the one little thing

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which was that your roommate borrowed one hundred thousand dollars

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to buy out all of her options at that time

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a risky move because of the company had gone bankrupt

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or done poorly Well that hundred grand would have been

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probably zero fast however because they were ice oes She

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did not pay any tax on that exercise so pay

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it when she sells them at a long term gain

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Right Right So then along comes an Ai po and

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the stock rocks in the four years Pass and Shmoop

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Flix is conveniently for this example problem Hovering around thirty

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one dollars a share it is thirty bucks in the

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money and then you both go to sell well Your

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roommate pays a twenty five percent ish long term gains

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rate tax on the thirty dollars times one hundred thousand

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or three million bucks That is she pays seven hundred

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fifty grand in taxes to net to point two five

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million You however pay fifty percent ordinary income tax on

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the three million bucks in gain to net one point

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five million And remember she had a hundred grand invested

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with the company for four years and it took a

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lot more risk than you did So if you're feeling

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bad well tough beans you paid a lot of tax

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so it's a good problem to have But wow the

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little word non on your qualified options A plan cost

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you seven hundred fifty thousand dollars of winnings in the

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form of taxes Ouch So this sounds like Silicon Valley

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magic where everyone gets rich and becomes a millionaire by

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the time they finish their bar mitzvah speech Oh so

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not the case In fact most startup companies in Silicon

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Valley go fully bankrupt So had a tax avoiding Mohr

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greedy than fearful employee about out all their options qualified

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or not And then the company was sold for two

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thirds of the value of its preferred stock investment Will

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the common stock would be wiped out worthless and all

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the money the employees spent buying out there ISOs would

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be gone So the business of betting big on start

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ups is not one for the faint of heart but

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going in The presumption is that well you've carefully watched

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this video and others on shmoop finance and you know

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the witch and the warlock dance between risk and reward

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makes sense you know make dollars

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