Tax planning and compliance for investors Free Newsletter. What you need to know when you exercise nonqualified stock options. Your nonqualified stock option gives you the right to buy stock at a specified price. You exercise that right when you notify your employer of your purchase in accordance with the terms of the option agreement. The precise tax consequences of exercising a nonqualified stock option depend on the manner of exercising the option.
But in general you'll report compensation income equal to the bargain element at the time of exercise. The rules described here apply if the stock is vested when you receive it. Generally, stock is vested if you have an unrestricted right to sell it, or you can quit your job without giving up any of the value of the stock. See When Stock Is Vested. If the stock isn't vested when you exercise the option, apply the rules for restricted stock described in Buying Employer Stock and Section 83b Election.
The bargain element in the exercise of an option is the difference between the value of the stock on the exercise date and the amount paid for the stock. The value of the stock should be determined as of the date of exercise. For publicly traded stock the value is usually determined as the average between the high and low reported sales for that date.
For privately held companies the value must be determined by other means, perhaps by reference to recent private transactions in the company's stock or an overall appraisal of the company. Fair Market Value of Stock Bargain element as income The bargain element in the exercise of an option received for services is considered compensation income. You're not allowed to treat this amount as capital gain.
The amount of tax you'll pay depends on your tax bracket. If you exercise a large option, it's likely that some of the income will push up into a higher tax bracket than your usual one. The important thing to focus on — ahead of time if possible — is that you have to report this income, and pay the tax, even if you don't sell the stock.
You haven't received any cash; in fact, you paid cash to exercise the option, but you still have to come up with additional cash to pay the IRS. This is one reason advance planning is important in dealing with options. If you're an employee or were an employee when you received the option , the company is required to withhold when you exercise your option. Of course the withholding obligation must be satisfied in cash. The IRS won't accept shares of stock!
There are various ways the company can handle the withholding requirement. The most common one is simply to require you to pay the withholding amount in cash at the time you exercise the option. The amount paid must cover federal and state income tax withholding, and the employee share of employment taxes as well. The amount paid as income tax withholding will be a credit against the tax you owe when you report the income at the end of the year. You may end up owing tax on April 15 even if you paid withholding at the time you exercised the option, because the withholding amount is merely an estimate of the actual tax liability.
Withholding on Stock Non-employees If you aren't an employee of the company that granted the option and weren't an employee when you received the option , withholding won't apply when you exercise it.
Remember that this is compensation for services. In general this income will be subject to the self-employment tax as well as federal and state income tax. It's important to keep track of your basis in stock because this determines how much gain or loss you report when you sell the stock. When you exercise a nonqualified option your basis is equal to the amount you paid for the stock plus the amount of income you report for exercising the option.
The gain will be capital gain, not compensation income. For certain limited purposes particularly under the securities laws you're treated as if you owned the stock during the period you held the option.
But this rule doesn't apply when you're determining what category of gain or loss you have when you sell the stock. You have to start from the date you bought the stock by exercising the option, and hold for more than one year to get long-term capital gain. The description above assumes you exercised your nonqualified option by paying cash. There are two other methods of exercising options that are sometimes used. One is the so-called "cashless" exercise of an option. The other involves the use of stock you already own to pay the exercise price under the option.
These methods, and their tax consequences, are described in the pages that follow. A publication of Fairmark Press Inc. Thomas - About our website About our author Contact us Privacy.
Compensation in Stock and Options. Consider Your Options A plain-language guide for people who receive stock options or other forms of equity compensation. Equity Compensation Strategies A text for financial advisors and other professionals who offer advice on how to handle equity compensation including stock options. Capital Gains, Minimal Taxes Tax rules and strategies for people who buy, own and sell stocks, mutual funds and stock options. That Thing Rich People Do. A plain-language guide for people who receive stock options or other forms of equity compensation.
A text for financial advisors and other professionals who offer advice on how to handle equity compensation including stock options. Capital Gains, Minimal Taxes. Tax rules and strategies for people who buy, own and sell stocks, mutual funds and stock options.More...