Companies can offer nonqualified stock options (NSO) to employees or independent contractors as compensation for services rendered. An NSO enables the worker to purchase shares of stock in the company a set, predetermined price.
The value of the nonqualified stock option, minus the price paid to exercise the option, is treated as additional compensation to the employee or independent contractor. Under typical NSO plans, this income is measured and taxed on the date the worker exercises the NSO. Although in some circumstances, this income is measured and taxed on the date the NSO is granted. Which date we report the income depends on whether the NSO has a readily ascertainable market value.
Additionally, stock acquired through an NSO is taxed as capital gain income when the stock is sold.
Quick Overview of Option Terminology
- Strike Price or Exercise Price – the set price at which a worker can purchase stock. This price is set at the time the options are granted and does not change over time.
- Fair Market Value (FMV) – reflects the value of a company’s stock at a particular point in time. For stocks traded on the open markets, the fair market value is determined by the average of the highest and lowest selling prices of the stock on a particular day. For privately-held businesses, the fair market value would be determined by a formal appraisal.
- Spread or Bargain Element – The fair market value of the stock minus the strike price of the stock option.
Nonqualified stock options go through five phases during its lifecycle:
- Grant – when the company grants the stock option award package to a worker.
- Vest – when a stock option becomes available to exercise.
- Exercise – when the worker uses the option to purchase stock.
- Hold – the period of time during which the worker owns the stock.
- Sale or disposition – when the worker sells or otherwise disposes of the stock.
Determining the Tax Treatment of Nonqualified Stock Options
NSOs have different tax treatments depending on whether they have a “readily ascertainable market value” at the time the NSO is granted. If the NSO does have a readily ascertainable market value, then the NSO is taxed when granted. Otherwise, the NSO is taxed when the worker exercises the NSO.
NSOs have a readily ascertainable market value only if the stock option is actively traded on an established market, or if the NSO meets all of the following four conditions:
- The employee or contractor can transfer the NSO;
- The employee or contractor can exercise the NSO immediately;
- The NSO is not subject to restrictions or any condition that would have a significant impact on the market value of the NSO; and
- The market value of the option can be readily determined using rules set forth in the regulations.
NSOs rarely meet these requirements. As a result, it is typical for NSOs to be subject to tax when exercised.
Tax Treatment when Nonqualified Stock Options are Granted
Typically, NSOs are not taxed when companies grant the NSOs to their workers.
If a nonqualified stock option has a readily ascertainable market value, then the value of the NSO is taxed when granted. The taxable amount is the fair market value of the NSO on the grant date, minus the amount paid by the worker to exercise the option.
Tax Treatment when Exercising Nonqualified Stock Options
If the NSO did not have a readily ascertainable market value at the time the NSO was granted, then the spread between the fair market value of the NSO on the exercise date, minus the exercise price paid by the worker, is added to the worker’s compensation.
Tax Treatment of Compensation Income
The spread between the market value of the NSO and the exercise price is treated as compensation income.
For employees, this compensation income is added to their wage income. The compensation income is subject to federal and state income taxes, Social Security tax, and Medicare tax. The employer will include this amount on the employee’s Form W-2 for the year, and indicate the amount of the spread in Box 12 with code V.
For independent contractors, this compensation income is added to their self-employment income. The compensation income is subject to income tax and self-employment tax at the federal level, plus any state income tax. The company will include this amount on the contractor’s Form 1099-MISC for the year.
Tax Treatment when Stock is Sold
After the non-qualified stock option vests, the worker owns shares of stock that are freely transferrable. At some point, those shares might be sold. Selling the shares will trigger a new tax impact.
When stock is sold, the individual reports capital gain income for the difference between the gross proceeds from selling the stock minus the adjusted cost basis of the stock.
The cost basis of the stock acquired by exercising an NSO is the exercise price plus compensation income (the amount included as income when the NSO vested) plus any brokerage fees and commissions.
If the stock is held more than one year from the exercise date, then the gain from the sale of the stock is classified as long-term gain subject to the lower capital gains tax rates.
If the stock is held one year or less from the exercise date, then the gain is classified as short-term gain and subject to the ordinary tax rates.
Tax Move Takeaways
- If possible, consider exercising NSO when the fair market value of the stock is equal to the strike price, thereby eliminating the compensation income component.
- If it makes sense from an investment perspective, consider holding the shares more than one year from the exercise date to qualify for the lower long-term capital gains tax rates.
Summary of Tax Treatment of Nonqualified Stock Options
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