What Makes a Nonstatutory Stock Option Taxable Upon Grant?

A nonstatutory stock option (NSO) is a form of compensation that gives an employee the right to purchase company stock at a predetermined price, known as the exercise or strike price. NSOs provide a straightforward method for employees to share in the company’s growth, but their tax implications can be complex. This article will clarify the specific and uncommon circumstances under which an NSO becomes taxable to the recipient immediately upon being granted.

The General Rule for NSO Taxation

The typical life cycle of an NSO involves three events, but only two usually have tax consequences. The first, the grant date, is not a taxable event under the general rule because the option’s ultimate value is uncertain. The first significant tax event occurs at exercise, when the employee purchases the stock at the predetermined strike price.

The difference between the fair market value (FMV) of the stock and the exercise price is taxed as ordinary income. This spread is treated as compensation and is subject to federal and state income taxes, as well as Social Security and Medicare taxes, which the employer withholds and reports on Form W-2.

The final event is the sale of the stock. When the employee sells the shares, any appreciation in value from the exercise date to the sale date is treated as a capital gain. The holding period for determining whether the gain is short-term or long-term begins on the day after the option is exercised. A sale within one year of exercise results in a short-term capital gain, while a sale after holding the stock for more than a year qualifies for long-term capital gains rates.

Conditions for Taxation at Grant

While taxation at exercise is the norm, Internal Revenue Code Section 83 provides an exception that triggers taxation at the grant date. This happens only if the option has a “readily ascertainable fair market value” when granted, a standard that is difficult to meet. An option’s value is considered readily ascertainable if the option itself is actively traded on an established market. Since employee stock options are private agreements and not publicly traded, this is almost never the case.

If the option is not traded, it must satisfy a four-part test to be taxed at grant.

• The option must be transferable by the employee.
• The option must be immediately exercisable in full.
• The option or the underlying stock cannot be subject to any restriction that has a significant effect on the option’s value.
• The fair market value of the “option privilege” must be readily ascertainable.

The option privilege is the value of being able to benefit from future stock appreciation without paying for the stock upfront. Most employee stock option agreements prohibit transfer or include vesting schedules, preventing them from being immediately exercisable. These common restrictions mean most NSOs do not meet the test for taxation at grant.

Calculating and Reporting Tax at Grant

In the rare event that an NSO has a readily ascertainable fair market value at grant, the tax treatment shifts. The fair market value of the option itself is treated as ordinary compensation income to the employee in the year the option is granted. This income is subject to all applicable employment taxes, including federal income tax withholding, Social Security, and Medicare.

The employer is required to report this compensation on the employee’s Form W-2 for the year of the grant. The amount of income recognized establishes the employee’s cost basis in the stock option. For example, if an option valued at $1,000 is taxed at grant, the employee’s basis becomes $1,000.

With this upfront taxation, there is no tax consequence when the employee later exercises the option. The holding period for capital gains purposes also begins on the grant date. When the stock is sold, the difference between the sale price and the basis (the exercise price plus the amount taxed at grant) is a capital gain or loss.