How Are Non-Qualified Stock Options Taxed?

Stock options are a common form of equity compensation, offering individuals the opportunity to gain from a company’s growth. Non-Qualified Stock Options (NSOs) are frequently used, providing recipients the right to purchase company stock at a predetermined price. Understanding the tax implications of NSOs is necessary for recipients. This article explains how NSOs are taxed throughout their lifecycle, from exercise to sale.

Key Characteristics of Non-Qualified Stock Options

Non-Qualified Stock Options grant an individual the right, but not the obligation, to buy a company’s stock at a set price, known as the grant price or exercise price, within a specific timeframe. Unlike Incentive Stock Options (ISOs), NSOs do not meet certain Internal Revenue Service (IRS) requirements for preferential tax treatment, making them a more flexible option for companies to offer to a broader range of service providers, including employees, consultants, and advisors.

The lifecycle of an NSO involves three stages: grant, vesting, and exercise. The grant date is when the company first offers the options, usually setting the exercise price at the stock’s fair market value (FMV) at that time. Vesting refers to earning the right to exercise the options, often based on a time schedule, such as remaining with the company for a certain number of years, or achieving specific performance milestones. Once vested, the individual can exercise the option, purchasing the company’s common stock at the pre-established grant price.

The “spread,” also known as the “bargain element,” represents the difference between the FMV of the stock on the date of exercise and the lower exercise price. If the stock’s market price is below the grant price, the options are considered “out-of-the-money” or “underwater.”

Taxation When You Exercise Your NSOs

Exercising Non-Qualified Stock Options is a taxable event. The difference between the fair market value (FMV) of the stock on the exercise date and the exercise price, known as the “spread,” is treated as ordinary income. This income is considered compensation, similar to regular wages, and is subject to federal income tax, Social Security tax, and Medicare tax.

Employers are required to withhold these taxes when an employee exercises NSOs. This withholding includes federal income tax, Social Security, and Medicare taxes on the ordinary income recognized. This income is reported on the employee’s Form W-2, usually in Box 1 as wages, and is often noted in Box 12 with Code V. If the individual is a non-employee, such as a consultant, the income may be reported on Form 1099-NEC.

The FMV at the time of exercise becomes the new cost basis for the shares. This adjusted cost basis includes both the exercise price paid and the amount of ordinary income recognized at exercise. For example, if shares are exercised at $10 with an FMV of $50, the $40 spread is taxed as ordinary income, and the new cost basis per share becomes $50. This new basis is used for calculating any future capital gains or losses when the shares are eventually sold.

Taxation When You Sell Your Shares

After exercising NSOs, any subsequent gain or loss from selling the shares is subject to capital gains tax. This capital gain or loss is calculated based on the difference between the sale price and the adjusted cost basis. The cost basis is the fair market value of the stock on the exercise date, including the exercise price paid and the ordinary income recognized.

The tax rate applied to this capital gain depends on the holding period of the shares after exercise. If the shares are held for one year or less after the exercise date, any profit is considered a short-term capital gain. Short-term capital gains are taxed at the individual’s ordinary income tax rates, which can be higher than long-term rates.

If the shares are held for more than one year after the exercise date, any profit upon sale is classified as a long-term capital gain. Long-term capital gains benefit from lower tax rates compared to ordinary income tax rates, providing a potential tax advantage. If the shares are sold for less than their adjusted cost basis, a capital loss occurs, which may be deductible against other capital gains and potentially a limited amount of ordinary income.

Reporting NSO Income and Sales

Reporting income and sales related to NSOs involves several tax forms. The ordinary income recognized at NSO exercise is reported by the employer on the employee’s Form W-2. This amount is included in Box 1, “Wages, tips, other compensation,” and is often indicated in Box 12 with Code V.

When the shares acquired through NSO exercise are sold, the transaction must be reported on IRS Form 8949, “Sales and Other Dispositions of Capital Assets,” and Schedule D, “Capital Gains and Losses.” Form 8949 lists the details of each stock sale, including the description, dates acquired and sold, sale proceeds, and cost or other basis. The subtotals from Form 8949 are carried over to Schedule D, where aggregate capital gains and losses are calculated. Accurately determining the acquisition date (the exercise date) and the sale date on these forms is important to establish the correct holding period and whether the gain or loss is short-term or long-term.