What defines a nonqualified stock option?
The IRS does not require special tax treatment for a type of employee stock option known as a Non-Qualified Stock Option (NSO). These are the primary points:
- Ordinary Income Tax: When you exercise NSOs, you pay ordinary income tax on the difference between the grant price (the price at which the option is granted) and the fair market value of the stock at the time of exercise.
- The grant of NSOs is flexible and can be given to both employees and non-employees like contractors or board members.
- NSOs are not subject to any statutory requirements, unlike ISOs.
- Ordinary income tax, Social Security, and Medicare taxes are applied to the spread (the difference between the grant price and the market value at exercise).
To calculate NSO profit and loss, here's an example.
- On February 1, 2017, Denise was given nonqualified stock options (NSOs) by her employer, and they were sold for $5 per share.
- After the 2-year vesting period, Denise is allowed to purchase 100 shares of stock at $5 per share by the NSOs. The options will be terminated on February 1, Year 5.
- Denise will exercise her options on February 6, Year 3 when the stock's current trading price is $8 per share.
- It is necessary to hold for a period of 2 years. On December 19, Year 7 with a price
- of $20 per share, Denise sold 50 of the 100 shares.
When Denise exercises her NSOs on February 6, Year 3, what will she be recognizing in terms of income?
- The right to purchase stock at a specific exercise price (strike price) is granted through stock options at a specific point in time.
- On the grant date, there is no recognition of income.
- Ordinary income is recognized on the exercise date for NSOs due to the bargain element (FMV at the exercise date minus strike price).
- The basis is equal to the FMV when exercising. When the stock is sold, any additional capital gains or losses are acknowledged.
- Denise's exercise of the NSOs on February 6, Year 3 results in ordinary income being recognized due to the difference between the FMV at the exercise date and the strike price.
- Denise will recognize $300 as ordinary income (which is equivalent to $8 less $5) when multiplied by 100 shares.
