A nonqualified stock option (NSO) is a type of stock option that does not meet the requirements for tax-favored treatment like incentive stock options. NSOs are the most widely used type of employee stock option because there are few restrictions on their use or structure. They are the option of choice for most employee stock option plans that cover all or a significant number of a company's employees.

Nonqualified stock options permit you to buy shares of the company's stock at a fixed price for a fixed period.

NSOs often come with a vesting schedule such as the one discussed in Lesson 4, "All About Vesting, Lock-Ups, etc." This schedule may be for any period, but frequently is complete in three or four years.

Employers can issue multiple grants over a period; however, they are under no obligation to continue doing so. If business conditions change, employers may discontinue employee stock options or suspend them until circumstances change.

One of the most attractive features of NSOs (from the employer's perspective) is that there are few rules governing the granting of nonqualified stock options.

For example, an employer can decide which employees are going to get options, how many, and when they vest. This flexibility lets the employer design a broad-based stock option plan that fits corporate goals.

Many young companies (and some older ones) want to preserve their cash to pay for growth and use options as a way to reward employees without draining the bank account.

Companies can grant NSOs that vest immediately or after a short period. This type of option has the effect of being a noncash bonus that allows employees to cash in the options whenever they want (within the grant period).

Immediately vested options often have a shorter grant term than other types of options. Companies can issue NSOs at or below the market price of the underlying stock, creating immediate value in the option.

Nonqualified stock options do not have a limit on the grant price. Employers can't issue ISOs for less than the fair market value of the underlying stock on the day of the grant.

Companies can issue NSOs for any grant price over, at, or under the fair market price of the underlying stock on grant day. Generally a company will not issue an ISO for less than 15 percent under the fair market price of the underlying stock due to securities rules that come into play.

Employers use this discount feature to create the cashless bonus discussed earlier. For example, a company could grant stock options for 100 shares of stock, immediately vested, with a grant price of $21.25 per share. The stock has a fair market value of $25 on grant day.

An employee could immediately exercise the option and sell the stock. He would realize a $375 profit.

The higher the price of the underlying stock, the bigger the bonus for the employee. For example, a company could grant stock options for 100 shares of stock, immediately vested, with a grant price of $85 per share. The stock has a fair market value of $100 per share on grant day.

An employee could immediately exercise the option and sell the stock. In this example, he would realize a $1,500 profit.

Depending on your financial situation, it might make more sense to forgo the immediate profit and hold the option for a longer period. You may find an even larger return by waiting. I will discuss when to exercise your options in more detail in Lesson 7, "When to Exercise Your Options."

Using the last example, it is easy to see that holding the option while the stock appreciates is a good idea, although not always the best idea. This assumes a rising stock price, no guarantee in any market.

Some companies use employee stock options as motivation for achieving certain corporate goals.

For example, a company wants to increase market share and sets that as a goal. Management knows that if it achieves the goal, the stock's price will likely rise.

The company grants NSOs with an exercise price that is 5 percent higher than the fair market value of the underlying stock. The hope is that employees will work harder to achieve the goal, knowing that the price of the stock will rise.

Unfortunately, the stock market is not always an accurate reflection of management's goals. Any number of factors outside the company's and employee's control may prevent the stock's price from rising even if it achieves the goal.

Employee stock option proponents disagree sharply over the value of options as motivators. Using the preceding scenario, employees may be motivated to achieve the goal only to find the company's stock depressed by external influences.

Nonqualified stock options are the most widely used form of equity compensation. The main reason for this popularity with employers is their flexibility.

Companies can offer NSOs to all employees or certain groups of employees. For example, the sales force might receive NSOs tied to market share growth, while the production workers receive NSOs tied to lowering costs.

NSOs, as anything a company does, must be nondiscriminatory. For example, companies can't offer options to men and not women or only to white employees.

Most of the benefits you receive from your employer must cover all employees by law. Qualified retirement plans must cover all full-time employees, for example. NSOs do not have these restrictions.

If you are not an employee and receive stock options, they are always nonstatutory stock options.

Nonstatutory stock options do not have a limit on the amount of stock you can receive in a single year.

In Lesson 5, "Incentive Stock Options," I noted that you couldn't exercise more than $100,000 in incentive stock options in any one year. No such limit exists for NSOs.

Nonqualified stock options or nonstatutory options do not qualify for any special tax treatment.

You incur a tax liability at the time of grant if there is a readily available way to establish a value on the options. There are almost no circumstances where this is the case.

The most common scenario is that employees exercise the options and immediately sell the stock for a profit. Any income from this transaction is ordinary income to the employee. In Lesson 8, "Exercising Your Options," I discuss various ways to exercise your options.

For example, you receive nonstatutory stock options for 100 shares of stock worth $30 per share at the time of grant with an exercise price of $35 per share. After vesting, you want to exercise your options. The current price of the stock is $45 per share.

You exercise the options and immediately sell the stock. What is your tax liability? First, we need to compute your profit. The exercise price was $35 per share and you sold the stock for $45 per share. Your profit is $1,000 (not including fees and taxes).

You owe ordinary income tax on the $1,000. Normally you would not pay the tax until you filed your income tax for that tax year. However, if you make estimated tax payments, consult your tax professional for advice on how to handle your profit.

What happens if you decide to hold the stock for a while and then sell it? Using the same scenario as above, suppose you decided that rather than sell the stock immediately, you want to hold it for future growth.

You still owe ordinary tax on the $1,000 and you may own capital gains tax on the stock if you hold it for more than one year.

For example:

You hold the stock for two years and sell it for $55.

Your tax liabilities are: first, ordinary income tax on the $1,000 difference between the grant price and the market price on the day you exercise the options and buy the stock; second, you may owe long-term capital gains tax on the spread between your basis and the market price:

Your basis in this case is the $35 grant price you paid for the stock plus the income you reported ($10 per share). This means the next tax issue starts at $45 per share rather than $35 per share.

I spend more time on taxes in Lessons 9 and 10, "Taxes and Your Options."