Non-qualified stock options grant employees and certain non-employees, such as consultants and board members, the right to purchase company shares at a fixed price (known as the exercise price, grant price, or strike price) within a set timeframe. The strike price, determined by the company’s 409A valuation or fair market value, remains fixed, allowing individuals to potentially profit if the share price increases over time. NSOs are often used as a form of compensation and are used by companies to attract, retain, and motivate employees.
When Are You Taxed on Non-Qualified Stock Options?
At the grant date, receiving NSOs does not trigger any federal tax obligations, as it only gives the right to purchase shares at a fixed price within a specified time. Similarly, vesting does not create a taxable event, though it marks the earliest you can exercise your options. Taxes are owed only when you exercise your NSOs, meaning when you buy the shares at the exercise price. The taxable amount, known as the “bargain element,” is the difference between the exercise price and the fair market value at the time of exercise. This amount is subject to ordinary income tax, including Social Security and Medicare taxes (FICA), and may also include state and local taxes. If you’re an employee, your company will typically withhold these taxes, while non-employees must pay them directly.
Example
Here’s an example of exercising non-qualified stock options (NSOs) and how the income is calculated:
- Number of Options Exercised: 10,000 shares
- Exercise Price (Strike Price): $5 per share
- Fair Market Value at Exercise (FMV): $25 per share
Bargain Element
The difference between the FMV and the exercise price is the bargain element, which is taxable income. In this case:
- Bargain Element = 10,000 shares × ($25 - $5) = $200,000
Taxable Income
The $200,000 (the bargain element) is subject to ordinary income tax. This means that when you exercise the options, you will report $200,000 as compensation income for tax purposes.
If you’re in the highest tax bracket of 37%, your federal income tax due would be $74,000.
How Do You Pay the Tax Due on Exercise?
Many people don’t have $74,000 readily available to pay the taxes due, so one common approach is the sell-to-cover method. This allows you to exercise your options and sell some of the shares at the same time to cover the tax liability.
In our example, you would need to sell 2,960 shares (74,000 federal tax liability ÷ 25 FMV at exercise). This would generate enough cash to cover the federal tax liability, leaving you with 7,040 shares worth $176,000. Keep in mind you will also need to sell shares to cover FICA and state income taxes.
Please note, some employers will only sell enough shares to cover the supplemental tax rate (22%) and therefore the amount of tax withheld in the sell-to-cover may not fully cover your tax liability.
Similar to a sell-to-cover transaction used to cover taxes, a cashless exercise allows someone to sell shares immediately to cover the cost of exercising their stock options.
What Are the Tax Implications on Sale?
If you sell the stock at a price higher than the FMV at the time of exercise you will have a capital gain. If you sell the stock below the FMV at which you exercised you will have a capital loss. If you hold the stock longer than one year from date of exercise, any gain will be taxed at preferential long-term capital gains rates (0,15, or 20%). If you fail to meet the one-year hold period, any gain on sale will be taxed at ordinary rates.
Other Considerations
- If at the time you exercise your stock, your shares qualify as qualified small business stock under section 1202, you can potentially exclude up to $10,000,000 of gain or 10x your basis upon sale.
- Some companies allow employees to early exercise their NSO’s before the shares vest and at a lower valuation which results in less tax on exercise. If your company allows an early exercise, you should file an 83(b) election with the IRS.
- If you fail to exercise your option before expiration, they usually will become worthless as you no longer have the option to own these shares. After leaving a company, you usually have a limited timeframe to exercise your stock options.
To better understand your non-qualified stock options, please consult with your Withum tax advisor before exercising and selling your options.
Author: Evan Finer, CPA, CFP | [email protected]
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