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Nonqualified stock options (NSOs) and taxes

Key takeaways

  • Different types of employee stock option programs are treated differently for tax purposes.
  • Exercising NSOs results in ordinary income to the participant on the difference between the grant price and current market value of the stock.
  • A tax professional can help you assess the tax impact of exercising stock options and help manage your tax liability.

A stock option is the opportunity, given by your employer, to purchase a certain number of shares of your company's common stock at a pre-established price, known as the grant price, over a specific period of time, known as the vesting period. The difference between the price of the stock and the grant price is what creates value for the participant. There are 2 types of stock options, classified by their tax status and regulatory requirements: statutory or incentive stock options (ISOs) and nonqualified stock options (NSOs).

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What are nonqualified stock options?

Nonqualified stock options are more traditional stock options that do not meet certain IRS requirements that allow you special tax treatment. With NSOs, you will be taxed when you exercise the stock options. The IRS levies ordinary income tax, Social Security tax, and Medicare taxes on the difference between the fair market value when you exercise the stock options and the grant price.

How do nonqualified stock options work?

First let's review the terms commonly associated with this type of equity compensation:

  • Exercise: Exercising a stock option means purchasing the company's common stock at the grant price, regardless of the stock's price at the time you exercise the option.
  • Grant price: The price at which the option is initially granted to the participant. This is also referred to as the strike price or the exercise price. Under most plans, this is set at the fair market value of the stock at the time the grant is made.
  • Spread or in-the-money value: The difference between the grant price and market value of the stock at the time of exercise. If the market price of the stock is below the grant price, the options are said to be out-of-the-money or underwater.
  • Option term: The length of time an employee can hold the option before it expires, at which point it is no longer exercisable.
  • Vesting: Requirement(s) that must be met to have the right to exercise an option. Usually the requirement is time-based related to continuous service, but could be dependent on a particular triggering event such as a specified performance goal or the initial public offering of the company.

Nonqualified stock options vs incentive stock options

The main distinction between nonqualified stock options and incentive stock options lies in the tax treatment. Incentive stock options have more statutory requirements and are only allowed to be granted to employees, whereas nonqualified option terms can be more flexible and may be granted to nonemployees, such as board members or contractors.

How are nonqualified stock options taxed?

Both option types are not taxed at the grant date. When an employee exercises nonqualified stock options, the spread on exercise (the difference between the fair market value of the stock and the grant price of the option) is taxable to the employee in the same year in which the option is exercised. In fact, it's included in compensation income, along with salaries and wages, and is reflected on IRS Form W-2 for tax reporting purposes (or a 1099 for non-employee participants).

Once acquired, the shares are assigned a cost basis equal to the price you paid for the option plus any ordinary income reported on your W-2. From there, any subsequent gain or loss realized by the employee upon the sale of the shares will be a capital gain or loss. If the stock is held for more than a year, long-term capital gains rates would apply.

If the options are exercised and the applicable shares are sold simultaneously (as is often the case), compensation income will still be recognized, with minimal capital gain or loss on the transaction. Because of trade timing and the way fair market value at exercise is determined and how capital gain or loss is calculated, there is quite often some capital gain or loss on the sale of the shares.

When should you exercise nonqualified stock options?

When to exercise nonqualified stock options can be a complex decision. Some factors you may want to consider include the current stock price, your expectations for future stock price appreciation, and your current and future tax situation. In addition, you'll want to carefully make sure you understand the rules of your employer plan, and how much time you have until your stock options expire.

The bottom line

Employee stock options may be offered as part of your compensation and create significant financial value, but to maximize their potential, it's important to understand and plan for their tax impact. A financial or tax professional can help you understand the features and taxation of your equity compensation and develop strategies to better capture their value and manage potential risks.

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Fidelity does not provide legal or tax advice. The information herein is general and educational in nature and should not be considered legal or tax advice. Tax laws and regulations are complex and subject to change, which can materially impact investment results. Fidelity cannot guarantee that the information herein is accurate, complete, or timely. Fidelity makes no warranties with regard to such information or results obtained by its use, and disclaims any liability arising out of your use of, or any tax position taken in reliance on, such information. Consult an attorney or tax professional regarding your specific situation.

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