Exploring Tax Rules for Non-Qualified Stock Options

On the surface, the tax rules associated with non-qualified stock options are relatively straightforward.

Upon receipt of non-qualified stock options, no taxes are due. Furthermore, these stock options are not taxable until you exercise your shares. This “exercise control” allows the option owner to defer income tax while potentially creating considerable wealth, should the value of the shares increase.

Eventually (assuming the options are “in-the-money”), it will make sense for the option holder to exercise their non-qualified stock options. And when they do, taxes will be due.

Typically, there are two types of taxes to consider during the lifespan of your non-qualified stock options:

  1. Compensation income – compensation income is taxed at ordinary income rates, and will be subject to Social Security and Medicare wage tax.
  1. Capital gains tax – capital gains are subject to ordinary income rates or long-term capital gain rates, depending on the holding period of the stock.

How much income is subject to compensation income and how much is subject to capital gains depends on several factors, including issue price, exercise price, holding period, and overall exercise strategy.

Taxation of Non-Qualified Stock Options at Issue and at Vesting

One attractive feature of non-qualified stock options is that the owner is not required to pay any tax when the options are issued. This allows the owner to participate in the unlimited upside of the stock price, all while deferring potential tax liability.

Furthermore, when the stock options vest, no taxes are due (this is substantially different from their restricted stock cousins).

Vesting simply means that the shares are now eligible to be exercised by the option holder.

Taxation upon Exercise of Non-Qualified Stock Options

Upon exercise of non-qualified stock options, taxes will be incurred. Specifically, the option owner will need to claim as compensation income the value of the bargain element. The bargain element is calculated as the difference between the grant price of the stock option and the exercise price of the stock option, multiplied by the number of shares. For example:

Number of Options Grant Price Exercise Price Bargain Element
2,000 $10.00/sh $50.00/sh $80,000

 

In this hypothetical example, we can see that 2,000 options were issued with a grant price of $10 per share. Assuming the value of the shares increased to $50.00 per share upon exercise, each share has a bargain element of $40. $40 per share multiplied by 2,000 shares equals $80,000 of reportable compensation income.

In addition, this compensation income is reportable regardless of whether or not the owner continues to hold the shares after exercise or decides to sell them immediately. Deciding whether to hold shares brings into question the decision of a cash exercise or a cashless exercise. In other words, can the option owner afford to exercise these shares?

Upon exercise, the cost basis of the shares is set and is equal to the exercise price times the number of shares exercised. In our example above, the cost basis is equal to 2,000 shares times $50/share, or $100,000.

The cost basis is important because it is used to calculate capital gain/loss upon a subsequent sale of the exercised stock.

Taxation upon Final Sale of Non-Qualified Stock Options

Upon exercise, you now become the outright owner of the shares. As the owner, you have the ability to sell the shares immediately or hold them indefinitely (although you may want to consider how concentrate equity fits into your financial plan). The period of time for which you retain ownership and the value of the shares dictate how they will be taxed.

Specifically, the shares will be subject to capital asset tax rates. These rates are different for short-term holding periods (less than one year) and long-term holding periods (anything that is not short-term).

Assuming a short-term holding period, in which you sell the shares less than one year after exercise, any gain will be taxed at ordinary income rates.

Assuming a long-term holding period of one year or more, any gain over the cost basis is subject to preferential long-term capital gains treatment. Below is a hypothetical example.

Cost Basis Current Value Capital Gain Tax Due After-Tax Value
Short-Term (28%) $100,000 $150,000 $50,000 $14,000 $136,000
Long-Term (15%) $100,000 $150,000 $50,000 $7,500 $142,500

 

Continuing our example above, we have established a cost basis of $100,000 for the 2,000 shares of stock. Let’s further assume the stock price has increased to the point where the 2,000 shares are now valued at $150,000.

And we’ll also assume that we have two scenarios to exercise—one short-term, taxed at 28%, and one long-term, taxed at 15%. In reality, this would mean the share values are the same, once prior to a one-year hold and once after the one-year holding period.

In our example, you can see the potential tax liability for the long-term capital gains rate is nearly 50% less than the short-term capital gains rate.

(While this illustration indicates a tax scenario, many factors should be considered if continuing to hold stock shares after exercise. Taxes are simply one factor in what is a potentially complicated planning question.)

Planning for Non-Qualified Stock Options

As mentioned earlier in this article, the taxation of non-qualified stock options is relatively simple. At exercise, the spread between the grant price and the exercise price is taxed the same as your other wage income.

Any subsequent gain/loss is taxed at capital asset rates.

However, tax planning is only one piece of sound stock option planning. Other factors should be considered when strategizing whether to exercise, hold, and/or sell non-qualified stock options.

In addition to how these fit into your overall financial plan, you may want to consider other non-qualified stock option strategies and the discussion of a cash vs. a cashless exercise.

Tax services are not offered through, or supervised by Lincoln Investment, or Capital Analysts.  The above figures are for illustrative purposes only and do not attempt to predict actual results of any particular investment.

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4 Responses to Exploring Tax Rules for Non-Qualified Stock Options

  1. Bouquet March 23, 2017 at 2:38 pm #

    Daniel, this is an excellent article and clarifies so much for me. I do, however, have one question. The article states that “Upon exercise, the cost basis of the shares is set and is equal to the exercise price times the number of shares exercised. In our example above, the cost basis is equal to 2,000 shares times $50/share, or $80,000.” I get $100,000 when I do the math, not $80,000. Am I doing something wrong or misunderstanding? Please let me know. Thank you.

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