What Are Non-qualified Stock Options, and How Can They Be Used as Incentive Compensation by LLCs Taxed as Corporations?

Congratulations, we’ve reached the halfway mark in our enlightening journey through the world of incentive compensation strategies! Your dedication to learning these complex topics is inspiring and will undoubtedly pay dividends as you steer your business towards success. Today, we delve into the realm of Non-Qualified Stock Options (NQSOs), a versatile tool in the toolkit of compensation strategies. NQSOs can offer a potent mix of motivation and rewards for your key team members, acting as a powerful retention and performance-driving instrument. Let’s unpack how they work, the tax implications associated with them, and weigh their advantages against any potential downsides. With a clear understanding of NQSOs, you can make informed decisions on whether they might be the right choice for your LLC taxed as a corporation.

Understanding Non-Qualified Stock Options

Non-Qualified Stock Options, or NQSOs for short, are simply the right to buy company stock at a set price during a set period. This price, known as the exercise price, is typically the fair market value of the stock at the time the options are granted. NQSOs differ from Incentive Stock Options (ISOs) in that they don’t qualify for special tax treatment under certain IRS requirements.

But what does this mean in terms of taxes? Well, let’s break it down:

When it comes to NQSOs, taxes are pretty straightforward. At grant, there’s no tax due, assuming the options don’t have a readily ascertainable fair market value. At vesting, again, there’s no tax.

The tax event happens at exercise. The difference between the fair market value of the shares and the exercise price (also known as the “spread”) is treated as ordinary income and subject to tax. Then, when the team member eventually sells the shares, any further gains (or losses) are treated as capital gains (or losses), either long-term or short-term, depending on how long they’ve held the shares.

But remember, while this tax scenario can sound less appealing than ISOs, NQSOs do offer more flexibility and can be a valuable part of your incentive compensation arsenal.

Perks of Non-Qualified Stock Options

Now, why should you, as a business owner or manager, consider NQSOs? There are several reasons that can make them a highly attractive incentive compensation tool.

  1. Flexibility: NQSOs are not bound by the stringent regulations that ISOs must adhere to. This means they can be adjusted and tailored to the specific needs and goals of your company.
  2. Tax Deduction: Your business can claim a tax deduction equivalent to the ordinary income the team member recognizes at the exercise of the NQSO. This is a unique benefit not available with ISOs.
  3. Broad Applicability: Unlike ISOs, NQSOs can be granted to non-employees, such as directors, consultants, and advisors. This gives you more options when deciding how to distribute your equity.
  4. A Powerful Incentive: Just like ISOs, NQSOs can serve as a robust motivation for employees, particularly in companies anticipating substantial growth.

However, no compensation tool is without its downsides. Let’s flip the coin and look at the potential disadvantages of NQSOs.

The Downsides of Non-Qualified Stock Options

While NQSOs can offer substantial advantages, it’s also important to understand their potential limitations.

  1. Exercise Price: The member must have the financial means to pay the exercise price in order to reap the benefits of their NQSOs. This is a hurdle that some may not surmount.
  2. Limited Upside if Stock Price Stagnates: The value of NQSOs is tied directly to the company’s stock price. If the stock price doesn’t increase, the incentive value of NQSOs can diminish.

In the end, like any strategic decision, the use of NQSOs as incentive compensation should be considered carefully, balancing the pros and cons based on your unique business needs and circumstances.


We hope this article has been informative and useful for your business. If you have any questions or comments, please contact us at info@wilkinsonlawllc.com. We plan to answer general questions in an upcoming FAQ series. If you need legal advice specific to your situation, please ask to schedule a consultation with an attorney to discuss your company’s goals.

Our next article will shed light on powerful tools LLCs taxed as corporations can use to attract and motivate employees: performance shares and performance share units. Join us tomorrow.

This article is for informational purposes only and should not be relied upon as tax or legal advice. Please consult professionals for advice tailored to your specific situation. The author and publisher assume no responsibility for any errors or omissions or for any actions taken based on the information presented.