How Is NSO Compensation Reported to an Employee?

Nonstatutory stock options (NSOs) are a common form of equity compensation that companies offer to employees, and sometimes even to non-employees like consultants and directors. An NSO provides the recipient with the right to purchase a specified number of company shares at a predetermined price, known as the exercise or strike price, within a certain timeframe. Unlike other types of stock options, NSOs do not qualify for special tax treatment under the Internal Revenue Code, meaning their taxation can still lead to significant tax obligations upon exercise. This guide clarifies how the financial gain from exercising these options is reported to an employee, focusing on tax documents and withholding procedures involved.

Determining the Taxable Compensation

The compensation from nonstatutory stock options becomes taxable at the point of exercise, which is when the employee chooses to buy the shares. This taxable amount is often referred to as the “bargain element” or “spread.” It represents the difference between the fair market value (FMV) of the company’s stock on the exercise date and the exercise price the employee pays per share.

To calculate this taxable compensation, the formula is: (Fair Market Value of stock on exercise date – Exercise Price per share) x Number of shares exercised. For example, if an employee exercises 1,000 NSOs with an exercise price of $10 per share when the stock’s fair market value is $30 per share, the taxable compensation would be ($30 – $10) x 1,000 shares = $20,000. This $20,000 is treated as ordinary income, similar to regular wages, and is subject to income tax withholding. This tax liability arises at the time of exercise, even if the employee does not immediately sell the acquired shares.

Reporting on Form W-2

The compensation derived from exercising nonstatutory stock options is considered supplemental wages and is included in an employee’s gross income. This amount is primarily reported on Form W-2, Wage and Tax Statement, which employers issue annually.

Specifically, the NSO compensation is included in Box 1 of Form W-2, labeled “Wages, tips, other compensation.” Furthermore, this compensation is subject to Social Security and Medicare taxes, also known as FICA taxes. Consequently, the NSO compensation is also included in Box 3 (“Social Security wages”) and Box 5 (“Medicare wages and tips”) of the W-2, up to the annual Social Security wage base limit.

NSO compensation is specifically identified in Box 12. The amount of income from the exercise of nonstatutory stock options is reported in Box 12 with Code ‘V’. This code serves as an informational note for the employee and the Internal Revenue Service (IRS), indicating that the amount included in Boxes 1, 3, and 5 originates from NSO exercise.

Additional Reporting and Withholding

Beyond the W-2, employees often receive supplementary documentation that details their nonstatutory stock option exercise. Brokerage firms, if the shares are held through them, or the employer directly may provide statements outlining the exercise transaction, the calculated compensation amount, and any taxes withheld. These statements are for informational purposes, helping employees reconcile the figures reported on their W-2 and track their investment.

Employers must withhold taxes on the NSO compensation at the time of exercise. This includes federal income tax, state income tax (if applicable), Social Security tax, and Medicare tax. Withholding occurs through specific mechanisms, such as reducing the number of shares the employee receives (a “sell to cover” approach) or by requiring the employee to make a cash payment to cover the tax liability. The amounts withheld for federal income tax, Social Security tax, and Medicare tax are then reported in Boxes 2, 4, and 6, respectively, on the employee’s Form W-2. State and local income taxes withheld will appear in their respective boxes on the W-2.

Form 3922, “Transfer of Stock Acquired Through an Employee Stock Purchase Plan Under Section 423(c),” is not used for reporting nonstatutory stock option exercises. This form is specifically for stock acquired through an Employee Stock Purchase Plan (ESPP) and does not apply to NSOs, which have different tax implications.