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How You’re Taxed When You Exercise your Non-Qualified Stock Options
Generally, you have to pay ordinary income taxes on the difference between the cost to exercise the options and the value of the options at the time you exercise them, even if you don’t sell the shares right away. So, as in the example above, it would be as if you earned an extra $1,000 in income and have to pay income taxes on that. You generally do not owe taxes when you are granted non-qualified stock options.
Rethinking Whether to Exercise and Hold Non-Qualified Stock Options for Long-Term Capital Gains Tax
ISOs resemble non-statutory options in that they can be exercised in several different ways. The employee can pay cash upfront to exercise them, or they can be exercised in a cashless transaction or by using astock swap. The profits on the sale of NSOs may be taxed as ordinary income or as some combination of ordinary income and capital gains, depending on how soon they are sold after the options are exercised.
Open market options
In one case we know of, an employee’s payroll department did not withhold federal or state income taxes. He exercised his options by paying $7,000 and sold the stock on the same day for $70,000 then used all the proceeds (plus additional cash) on the deal, to buy an $80,000 car, leaving very little cash on hand. Come tax return time the following year, he was extremely distressed to learn that he owed taxes on the compensation element of $63,000. If you’re an executive, some of the options you receive from your employer may be Non-qualified Stock Options. These are options that don’t qualify for the more-favorable tax treatment given to Incentive Stock Options. In this article, you’ll learn the tax implications of exercising non-qualified stock options.
When you exercise, you’re taxed on your phantom gain (a.k.a. spread) – the difference between the strike price of the NSO, and the 409A valuation at the time. In the worst case, it’s again taxed at ordinary income rates (the highest possible rate, just like your salary). Ordinary income tax rates are usually ~35-52% for our clients in California. We’ll assume 45% in this article – use our Stock Option Tax Calculator to get a personalized figure. Since what you paid for the stock was less than the market value, and the difference is reported on your W-2 form, the cost listed on the form 1099-B is understated. So, you have to change the cost basis reported on the 1099-B form when you report it in TurboTax.
Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision. The same wash sale rules that apply to stock also apply to stock option trades. If a substantially identical security is acquired within 30 days before or after the sale occurs, the loss is disallowed and the basis is transferred to the new position.
Continuing our hypothetical example from above, we can explore what happens after you exercise and hold non-qualified stock options. This is equal to the cost of the shares ($20,000) plus the amount claimed as compensation income ($80,000). We also assume tax rates for short-term capital gains are 33% and for long-term capital gains are 15% and the fair market value of the shares is $150,000.
Qualifying disposition refers to a sale, transfer, or exchange of stock that qualifies for favorable tax treatment. ISOs must be held for more than one year from the date of exercise and two years from the time of the grant to qualify for more favorable tax treatment. Other employers use thegraded vestingschedule, which allows employees to become invested in one-fifth of the options granted each year, starting in the second year from the grant.
How much tax you pay when you sell the stock depends on when you sell it. Unlike example 2, the compensation is calculated as either the bargain element or the actual gain from the sale of the stock – whichever is lower. This is because the market price on the day of the sale is less than that on the day you exercised your option.
When planning for your final sale of stock, it is important to understand what other income you have and how much room you have in various capital gains tax brackets. If you don’t meet the requirements you have a disqualifying disposition and the bargain element will be taxed as ordinary income. It won’t be subject to Social Security and Medicare wage tax (I point this out as a difference turbotax non qualified stock options between NSOs and ISOs. NSOs are subject to Social Security and Medicare wage tax). ISOs have a special holding period to qualify for capital gains tax treatment. The holding period is two years from the grant date, and one year after the stock was transferred to the employee. Your tax situation is unique in that, as you mentioned in a prior post, your stock is not publicly traded.
Hypothetical examples contained herein are for illustrative purposes only and do not reflect, nor attempt to predict, the actual results of any investment. The information contained herein is taken from sources believed to be reliable, however, accuracy or completeness cannot be guaranteed. Please contact your financial, tax, and legal professionals for more information specific to your situation. Because investment return and principal value fluctuate, shares may be worth more or less than their original value.
The employee is then fully vested in all of the options in the sixth year from the grant. ISOs are usually issued by publicly-traded companies, or private companies planning to go public at a future date, and require a plan document that clearly outlines how many options are to be given to which employees. Those employees must exercise their options within 10 years of receiving them.
All of the posts responding to this subject relate to situations where stock is publicly traded and thus, an employer can include the discount on a W-2 and the employee can adjust their cost basis accordingly. Moreover, as noted in prior posts, while you exercised your options, if you did not sell, there is no gain or loss to report. All you are left with is reporting the discount as ordinary income. However, ISOs can be more tax-friendly, as all earnings could potentially count as long-term capital gains (depending on holding periods). In contrast, with NSOs, the difference between the exercise price and fair market value at the time of exercising can be taxed as ordinary income. Non-qualified stock options are an alternative form of compensation that allows employees to gain equity in the employer’s company.
You sold the stock within two years after the offering date or one year or less from the exercise (purchase date). Follow the on-screen prompts the rest of the way through the process and enter proceeds, costs basis, etc. as you have calculated, and continue to enter the sales, one at a time. If they were part of your compensation (package) then the net amount you reported would also be self-employment https://turbo-tax.org/ taxable. The options are managed through carta.com, who has not sent me a tax form either. The good news is that regardless of the type of option you are awarded, you usually won’t face any tax consequences at the time you receive the option. Because the rules can be complex, we recommend options traders consider working with a tax professional who has experience in options taxation.
Any subsequent gain or loss from the date you exercise your options is taxed as a capital asset subject to capital asset rates. The bargain element is calculated as the difference between the exercise price and the market price on the day you exercised the options and purchased the stock. The bargain element is the difference between the exercise price and the market price on the day you exercised the options and purchased the stock. Your basis in the stock equals the amount of income included in your wages from exercising the options.
- If you exercise at least 12 months prior to selling – which is the case at A, B and C – your net gain is higher.
- Or you might exercise your options early, transitioning what may otherwise be compensation income into long-term capital gains (assuming a rising stock price).
- Employees hope to profit from exercising these options in the future when the stock price is higher.
When you exercise your non-qualified stock options, you should pay attention to the price at which you exercised. This price will dictate the cost basis of the shares moving forward. The cost basis is necessary because it is used to calculate capital gain/loss upon a subsequent sale of the exercised stock. For regular tax purposes, the cost basis of the ISO shares is the price paid—the exercise or strike price.
The basis shown on the 1099-B is often incorrect, so you may need to adjust it. If you sold the shares the same day you exercised the options, you should have little or no gain, and frequently a small loss due to trading expenses. Why do people use qualified stock options in spite of these restrictions? The reason is favorable tax treatment afforded to gains from QSOs.
For 2023 tax returns — those filed in 2024 — the deadline to file your return and pay any tax due is April 15, 2024. Individual states typically follow the IRS deadline but if you are unsure then check your state government’s website for more information. You sold the stock at least two years after the offering (grant date) and at least one year after the exercise (purchase date). The carta support team said the small company is responsible for the 1099-MISC, and the company does not seem concerned (because I am probably the only one in this situation for them). However, when you sell an option—or the stock you acquired by exercising the option—you must report the profit or loss on Schedule D of your Form 1040. The Charles Schwab Corporation provides a full range of brokerage, banking and financial advisory services through its operating subsidiaries.
And this time, the price per share increased from the offering date to the purchase date. Many large companies offer Employee Stock Purchase Plans (ESPP) that let you buy your employer’s stock at a discount. These plans are often offered as an employment incentive, giving you an opportunity to share in the growth potential of your company’s stock (and by implication, work hard to keep the stock price moving ahead). The value of ISOs becoming exercisable for the first time in any calendar year cannot exceed $100,000.
If this amount is not included in Box 1 of Form W-2, add it as “Other Income” on your Form 1040. You show the sale of the stock on your 2023 Schedule D. It’s considered long-term because more than one year passed from the date acquired (January 2, 2022) to the date of sale (January 20, 2023). That is good, because long-term capital gains are taxed at a rate that is lower than your regular tax rate.
With NSOs, you pay taxes both when you exercise the option and if/when you sell your shares. A non-qualified stock option (NSO) is a form of equity compensation that can be provided to employees and other stakeholders. An NSO gives you the choice to purchase shares of your company’s stock at a predetermined price, which can be profitable if the stock price rises above that level. The more your company’s share price grows, the more valuable your stock options become. This explains why employee stock options are a type of deferred compensation used to motivate and retain employees.
Advanced planning for non-qualified stock options may also mean exercising in calendar years when you are also exercising or selling incentive stock options as a means to increase or decrease the alternative minimum tax. Or you might exercise your options early, transitioning what may otherwise be compensation income into long-term capital gains (assuming a rising stock price). Stock shares acquired from an exercise and hold of non-qualified stock options are subject to capital asset tax rates. Short-term capital assets (assets that are held for less than one year) are taxed as ordinary income and long-term capital gains (assets that are held for one year or greater) are taxed at long-term capital gains rates. Generally speaking, long-term capital gains rates are lower and preferred over short-term capital gains rates. The biggest advantage of qualified stock options is the the bargain element is not considered ordinary income.
If you work for a constantly growing startup that ends up succeeding, the best tax strategy could be to exercise your NSOs as early as possible. The one advantage of NSOs is that how they are taxed is a bit more straightforward and easier to understand than with ISOs. Then the key to minimizing your tax burden (both at exercise and at sale) is to exercise as early as possible.
Qualified stock options are also called Incentive Stock Options, or ISO. A qualified employee stock option is known as a statutory stock option and offers an additional tax advantage for the holder. Outside of taxation, ISOs feature an aspect of what is called discrimination. ISOs can be informally likened to non-qualified retirement plans, which are also typically geared toward those at the top of the corporate structure, as opposed to qualified plans, which must be offered to all employees.
