Many employers look to attract and retain key employees through various investment-related incentives. One example is the nonqualified stock option (NQSO). If your employer provides these to you, or you’re considering an employer that does, make sure you’re up to speed on the applicable tax treatment and reporting.
HOW DO THEY WORK?
An NQSO is an option that doesn’t qualify for the special tax treatment afforded incentive stock options. Let’s look at an example: ABC Inc. grants an employee, Steve, NQSOs to buy 100 shares of the company’s stock for $100 per share – the fair market value (FMV) on the grant date.
The NQSOs vest over five years and must be exercised within 10 years. In Year 5, the stock’s FMV has increased to $150 per share, and Steve exercises all of his NQSOs, buying shares worth $15,000 (100 x $150) for $10,000 (100 x $100).
WHAT’S THE TAX IMPACT?
Generally, there are no tax consequences when NQSOs are granted. That said, the IRS has issued guidance regarding a variety of circumstances under which an NQSO grant requires you to report taxable income. This would be the case if the NQSO itself (as opposed to the underlying stock) has “readily determinable value.” But NQSOs granted by employers almost never satisfy this requirement.
When you exercise an NQSO, however, you must report compensation income equal to the spread between the exercise price and the stock’s FMV on the exercise date. Going back to the example, when Steve exercises his NQSOs, he must report $5,000 in compensation, which is taxable to him as ordinary income and deductible by his by his employer. It’s included in wages on Steve’s Form W-2 and is subject to payroll taxes.
HOW ARE SALES REPORTED?
Reporting income on the exercise of NQSOs is relatively simple. So long as the amount is reported properly on your W-2, it’s easy to report it correctly on your tax return.
To calculate and report gain on the sale of NQSO stock, you take the proceeds from the sale (net of any broker’s commissions or other expenses) and subtract you basis in the stock. The difference is short- or long-term capital gain, depending on how long you held the stock.
Generally, the basis is equal to the amount you paid for the shares (the exercise price) plus the amount of compensation income you reported upon exercise.
Suppose Steve, from the example above, holds his stock for two years and sells it for $18,000. His basis is $15,000 – the original exercise price of $10,000, plus the $5,000 he reported as wages. When he sells the stock, he will recognize $3,000 in long-term capital gain.
WHAT COULD GO WRONG?
NQSOs can be a valuable incentive. But, when selling stock acquired through the exercise of NQSOs, complications regarding the basis of the stock can sometimes arise. So please contact us for help calculating your basis and verifying the accuracy of your tax reporting.