A Look At Taxes On Nonqualified Stock Options

Stock options are a popular form of equity compensation and a powerful tool for building wealth. Companies can offer two types of stock options — non-qualified stock options (NSO) and incentive stock options (ISO). The taxes on nonqualified stock options are fairly easy to understand and don’t carry the complexities of incentive stock options. While they offer simplicity, it’s important to understand the tax implications for your financial plan.

At Grant

The grant date is when a company issues stock options. There is no tax due at the grant. Instead, you receive the option to purchase company shares at a specific price at some point in the future.

You’ll receive details at the time of grant, such as vesting schedules, expiration, number of stock options, and the grant price (sometimes called the strike price). However, typically you cannot take any action on the grant date.

At Vesting

After you meet the waiting period in the grant agreement, your options are vested. There is no tax due when nonqualified stock options vest. You have control of the options to continue holding or choose to exercise. Exercising is a taxable event, as discussed in the next section.

It’s important to know the details of your specific grant agreement. For example, you may have a certain number of stock options vest each year.

If you continue holding options, the stock price will fluctuate in relation to the grant price. As a result, they can be “in the money” and have value. In the money means the grant price (price you can buy the stock) is lower than the share price trading in the market.

Stock options can also be worthless for a period of time due to the grant price being above the market price of the stock. In this case, you could buy company stock on the market for cheaper than exercising your options.

As you hold options, you’ll likely see the value change drastically, depending on your company’s performance. In-the-money options can be extremely valuable because you can purchase your company stock much lower than the market price.

At Exercise

This is where the first tax component comes into play. Upon exercise of nonqualified stock options, you now own shares. In the year of exercise, you owe ordinary income tax on the difference between the grant price and the stock’s value at exercise. This is referred to as the spread. This amount is subject to federal, state, social security, and Medicare taxes. Generally, your employer will withhold taxes. For independent contractors, the income is subject to self-employment tax.

How it works in real life:

• You have NSOs with a grant price of $15.00/share.
• You exercise 100 options with the stock is trading at $45.00/share.
• The spread is $30.00 ($45 – $15).
• $3,000 ($30 * 100 options) is ordinary income (subject to federal, state, social security, and medicare).

Planning note: For 2021, you only pay social security tax on $142,800 of income.

At Final Sale

If you sell NSO shares immediately upon exercise, you won’t incur any additional taxes. However, choosing to hold shares after exercise brings in another layer of tax in the form of capital gains when you sell.

First, you’ll need to know your stock basis after exercise. The basis is determined by the price of the stock at exercise.

Real-life example continuation:

• Your basis after exercise is $45.00 (using numbers from the example above).

Sell shares within one year after exercise. Shares sold before the 1-year mark are taxed at short-term capital gains (or loss if sold below the basis). Short-term gains are taxed at ordinary-income rates.

Real-life example continuation:

• Your basis after exercise is $45.00.
• You sell the 100 shares of stock at $55.00 before the 1-year mark.
• Your short term gain is $1,000 ($55 – $45 = $10 * 100 shares).
• If we assume you’re in the 32% tax bracket, this creates a tax liability of $320.00 ($1,000 * 32%).

Sell shares more than one year after exercise. Shared sold after one year and a day qualify for more favorable long-term capital gains. In addition, long-term capital gains fall in the 0%, 15%, or 20% tax rates (loss if sold below the basis).

Real-life example continuation:

• Your basis after exercise is $45.00.
• You sell the 100 shares of stock at $75.00 after 1-year.
• Your long term gain is $3,000 ($75 – $45 = $10 * 100 shares).
• If we assume you pay 15% long-term capital gains, your tax liability is $450.00 ($3,000 * 15%).

In summary, whether you have various types of equity compensation or just NSOs, it’s important to understand the nonqualified stock options taxes in order to implement a proactive plan. The goal is to get the most out of your equity compensation and use money as a tool to create financial flexibility.

Taxes are just one of many reasons that go into the analysis of equity compensation. In other words, do what’s best for your financial plan first, then optimize for taxes. AKA, don’t let the tax tail wag the dog! If you are unsure where to start, a financial professional with expertise in this area can be worth pursuing. If you need help navigating your equity compensation or nonqualified stock options taxes, drop us a message or schedule a chat!