Look a little closer, however, and you'll see this is actually a good thing. NQSOs offer the opportunity to spread out your tax obligation, rather than getting hit all at once. Employers give employees NQSOs as a reward for hard work and loyalty. The NQSO allows an employee to purchase a certain number of shares of the employer's stock at a particular price. NQSOs often have vesting schedules -- employees must wait for a specific period of time before they can exercise the option.
The key idea behind all stock options is that the employer's stock price will go up. By the time you exercise an NQSO and buy stock, your exercise price will be lower than the market price of the stock, essentially giving you a discount. You can then hold the stock or sell it for a profit. Unlike most forms of compensation, however, NQSOs do not have any value until they are exercised. At the point of exercise, the value you receive is equivalent to the difference between your exercise price and the market price of the stock.
This is known as the compensation element, and the IRS considers it part of your compensation for the year. This compensation is part of your ordinary income and goes on your form with your other wages, tips and salaries.
In most cases, it will show up on your W-2 as part of your overall income, but verify this with your employer to make sure you report the correct amount.
Once you've exercised an NQSO, you have an investment. As with other investments, you'll calculate your gain or loss based on your cost basis, which is the original purchase price plus any commissions and fees related to the purchase and sale of the asset. With an NQSO, you get to step up your basis to the market value of the stock on the date of purchase, not the amount you actually paid for it.
This means that you don't pay any capital gains tax on the compensation element, which in many cases is a dramatic difference than if you'd purchased the stock outright. Once you sell the stock, you have a capital gain or loss, or you break even, just as you would with any other stock.
Remember, this gain or loss is the difference between your sale price and the stepped up cost basis. If you hold a capital asset, such as a stock for a year or less, it's considered a short-term gain and is taxed at ordinary income rates.
If you hold it for at least longer than one year, you have a long-term gain and it qualifies for a much lower tax rate. Nola Moore is a writer and editor based in Los Angeles, Calif. She has more than 20 years of experience working in and writing about finance and small business. She has a Bachelor of Science in retail merchandising. Capital Gain or Loss Once you sell the stock, you have a capital gain or loss, or you break even, just as you would with any other stock.More...