How Are Non-Qualified Stock Options Taxed?

Non-qualified stock options (NQSOs) are a form of equity compensation that grants an employee the right to purchase company shares at a predetermined price, known as the exercise or grant price. This price is set at the stock’s fair market value on the day the options are granted. The employee benefits if the stock’s value increases over time, allowing them to buy shares at a discount compared to the future market price.

Unlike Incentive Stock Options (ISOs), NQSOs do not meet certain IRS requirements for special tax treatment. This results in a more straightforward tax structure but can lead to a higher immediate tax liability for the employee. The tax implications are tied to when the options are exercised and when the resulting shares are sold.

Taxation at Grant and Vesting

When an employee is first granted NQSOs, there is no tax consequence. Receiving the right to buy stock in the future does not trigger a taxable event because the options do not have a “readily ascertainable fair market value” at the time of the grant. This means their future value is speculative and not yet realized.

Similarly, the vesting of NQSOs is a non-taxable event. Vesting is the period an employee must wait before they are allowed to exercise their options, for example, a grant may vest over four years with 25% becoming exercisable each year. As these options vest and become available for exercise, no income is recognized and no tax is due because the employee has not yet purchased any shares or realized any economic gain.

Taxation at Exercise

The main tax event for NQSOs occurs at exercise, when an employee purchases the company stock at their grant price. The difference between the fair market value (FMV) of the stock on the exercise date and the exercise price is the “bargain element.” This bargain element is considered compensation and is taxed as ordinary income in the year of exercise.

This income is subject to federal, state, and local income taxes, as well as Social Security and Medicare (FICA) taxes. The employer is required to withhold these taxes, just as they would from a regular paycheck. The income is taxed at the employee’s standard marginal tax rate.

To illustrate, imagine an employee was granted NQSOs with an exercise price of $10 per share. A few years later, when the stock’s FMV is $50 per share, they decide to exercise their option to buy 100 shares. The total exercise cost would be $1,000 (100 shares x $10). The total market value of these shares is $5,000 (100 shares x $50). The bargain element is the difference: $4,000 ($5,000 – $1,000). This $4,000 is treated as ordinary compensation income, and the employee will owe income and FICA taxes on this amount.

Taxation at Sale of Shares

After exercising the NQSOs and acquiring the shares, the next taxable event occurs when those shares are sold. The tax treatment depends on the holding period, which begins on the day after the options are exercised, not the original grant date.

The cost basis for NQSOs is the price paid to exercise the option plus the bargain element that was taxed as ordinary income at exercise. This structure prevents the same income from being taxed twice. Using the previous example, the cost basis for the 100 shares would be $5,000: the $1,000 exercise cost plus the $4,000 bargain element. This is equivalent to the stock’s market value on the day of exercise.

If the employee sells the shares for more than this cost basis, they will realize a capital gain. If they hold the shares for one year or less after the exercise date, the gain is short-term and taxed at ordinary income rates. If they hold the shares for more than one year, the gain is long-term and is taxed at the more favorable long-term capital gains rates. For instance, if the employee sells the 100 shares two years later for $70 per share ($7,000 total), their long-term capital gain would be $2,000 ($7,000 sale price – $5,000 cost basis).

Tax Reporting and Forms

Reporting NQSO transactions involves several tax forms. The compensation income realized upon exercise is included on your Form W-2. Your employer adds the bargain element to your wages in Box 1 of the W-2, ensuring that income and FICA taxes are correctly withheld and reported.

When the shares acquired from the exercise are sold, the transaction is reported by the brokerage firm on Form 1099-B. This form details the gross proceeds from the sale. The cost basis reported by the broker on Form 1099-B may not include the compensation component, sometimes only showing the exercise price paid.

You use the information from Form 1099-B to complete Form 8949. On this form, you must report the sale and make any necessary adjustments to ensure the correct cost basis is used, which includes both the exercise price and the bargain element. The totals from Form 8949 are then transferred to Schedule D, which summarizes capital gains and losses for your Form 1040.