Non-qualified Stock Optionss (NSOs) are a type of employee stock option that does not qualify for special tax treatments under the IRC. The taxation of NSOs depends on whether the fair market value (FMV) of the option can be readily determined at the time of grant. IRC §83, “Property transferred in connection with performance of services” governs taxation rules, and IRS Pub. 525, “Taxable and Nontaxable Income” explains reporting.
If the FMV of the option can be readily determined, the option is taxable at the time of grant.According to IRS Pub. 525, “Taxable and Nontaxable Income”, an option has a readily determinable FMV if it is actively traded on an established market. Other circumstances under which FMV can be readily determined include:
The option is transferable.
The option is immediately exercisable in full.
There are no conditions or restrictions (other than a condition to secure payment of the purchase price) that significantly affect the FMV.
The option privilege for an option to buy is the opportunity to benefit during the option’s exercise period from any increase in the value of property subject to the option without risking any capital. For example, if during the exercise period the FMV of stock subject to an option is greater than the option’s exercise price, a profit may be realized by exercising the option and immediately selling the stock at its higher value. The option privilege for an option to sell is the opportunity to benefit during the exercise period from a decrease in the value of the property subject to the option.
When these conditions are met, the employee must include the FMV of the option in their income at the time of grant. This amount is treated as ordinary income and is subject to income tax withholding and employment taxes.
Most NSOs do not have a readily determinable FMV. In such cases, the taxation occurs at the time of exercise, not at the time of grant.
No taxable event occurs when the option is granted.
When the option is exercised, the employee must include in income the FMV of the stock received minus the amount paid for the option (the exercise price).
This income is treated as ordinary income and is subject to income tax withholding and employment taxes.
When the employee eventually sells the stock, the difference between the sale price and the FMV at the time of exercise is treated as a capital gain or loss. This can be either short-term or long-term, depending on the holding period.
Suppose you are granted NSOs to buy 1,000 shares at $10 per share. The FMV of the stock at the time of exercise is $30 per share. You exercise the options when the FMV is $30:
No tax event.
You include $20,000 as ordinary income.
If you sell the stock later at $50 per share:
If you have income from the exercise of NSOs, your employer should report the amount to you on Form W-2, box 12, with code V. This amount represents the spread, which is the FMV of the stock over the exercise price of the options granted to you. Your employer should also include this amount in boxes 1, 3 (up to the Social Security wage base), and 5. If your employer is a railroad employer, this amount should be included in box 14.
If you are a nonemployee spouse and you exercise NSOs received incident to a divorce, the income is reported to you in box 3 of Form 1099-MISC.
When you sell stock acquired through the exercise of NSOs, there are no special income rules. Report the sale as explained in the Instructions for Schedule D (Form 1040) for the year of the sale. You may receive a Form 1099-B reporting the sales proceeds. Your basis in the property acquired under the option is the amount you paid for it plus any amount included in income upon grant or exercise of the option.
Your holding period begins on the date you acquired the option if it had a readily determinable value, or on the date you exercised or transferred the option if it did not have a readily determinable value.
For options granted on or after January 1, 2014, the basis information reported to you on Form 1099-B will not reflect any amount included in income upon grant or exercise of the option. For options granted before January 1, 2014, the basis information reported on Form 1099-B may or may not reflect any amount included in income upon grant or exercise; therefore, the basis may need to be adjusted.