Non-qualified Stock Option (NQSO) Taxes: A Guide
If you've been awarded Non-qualified Stock Options (NQSOs), you have the right— but not the obligation— to buy shares of your company's stock at a specific price. As your company's value grows, so may the value of your options, allowing you to potentially benefit from the growth.
This guide helps you understand how your NQSOs are taxed and what documents you'll need when filing in the United States.
NQSO overview
With NQSOs, your employer grants you stock options on a specific date (known as the "grant date.") Generally, you will not be able to exercise (purchase) the stock until the end of a predetermined waiting schedule (known as the "vesting period.") Once your options are vested, you have the right to exercise the stock at a fixed price (the "strike price" or "award price") set when you were granted the options.
When are NQSOs taxed?
With NQSOs, taxes typically come into play twice—when you exercise the stock and when you sell shares.
Taxes when you exercise stock
You're subject to ordinary income and FICA taxes when you exercise your award. You'll pay ordinary income taxes on the spread (the difference between the market price and the strike price, regardless of whether you decide to hold or sell the underlying stock.)
For example, Nancy decides to "exercise and sell" some of her NQSOs with the goal of receiving cash to buy a car. She exercises 3,000 options and immediately sells the option with a $15 spread, for a total of $45,000 of taxable income. Her company will withhold some of the proceeds to pay for ordinary income taxes and FICA. Nancy will receive the remainder of the money to fund her car purchase.
Taxes when you sell shares
With NQSOs, you'll be subject to capital gains tax on any increase in value you realize when you ultimately sell the shares.
For example, if the market value was $15 when you exercised your NQSOs and has risen to $20 when you sell your shares, that $5-per-share increase would be subject to either short-term (at ordinary income tax rates) or long-term capital gains tax. The amount you'll pay in taxes depends on how long you hold the shares after the exercise date.
If you sell your shares within a year of exercising, you'll likely pay ordinary income tax on the short-term capital gains profit you make.
If you hold your shares for at least a year (plus one day) before selling them, you'll likely pay long-term capital gains taxes on the profit you make selling your shares. Typically, long-term capital gains have a lower rate than short-term capital gains.
If the market price falls and you sell at that lower price, that's a capital loss, and you won't have a tax liability. You may be able to use that loss to offset other capital gains and/or up to $3,000 of your ordinary income.
What documents will I need to file taxes?
Here's an overview of the documents you may need when you're filing taxes and how you or your tax advisor will use them.
| Document | Why you need it | When to use it | Where you get it |
|---|---|---|---|
| Form W-2 | Form reports ordinary income and taxes withheld on your behalf. | To report taxable compensation after purchasing shares. | Your employer will provide it during tax season. |
| Form 1099-B | Form that reports your proceeds from investment sales. | To help calculate stock sale gains/losses when preparing your tax return. | From the broker that managed the stock sale (e.g. Charles Schwab). |
| Schedule D; Form 8949 | Forms where you detail the gains/losses from Form 1099-B and calculate capital taxes due. | To help calculate and report on stock sales capital gains/losses when you prepare your taxes. | From the IRS. |
| Form 1040 | Form you use to report income to the IRS. | When reporting annual taxes—you'll report award income and gains/loss from sale on the form. | From the IRS. |
Tax reporting after you exercise options
After you exercise your options, you'll receive a W-2 from your employer (or a 1099-NEC if you're a non-employee) during tax season that will report the income and taxes withheld on the spread.
Here are a few things to keep in mind when reporting NQSOs after exercising options:
- The IRS considers equity compensation ordinary income.
- Your spread typically is taxable in the year you exercise options.
- You are responsible for Social Security and Medicare taxes on the spread as well as income taxes, but this is typically withheld by your company.
What to do after exercising and selling shares?
After exercising and selling your shares, you'll report ordinary income and any potential capital gain or loss from the sale. Capital gains and losses are generally defined as the difference between the price you bought the stock for plus any transaction fees—or the cost basis—and what you sold it for (known as the "sale proceeds.")
What is cost basis and why is it important?
Calculating how much you gained or lost from the sale of stock depends on your cost basis. When you acquire the stock through a NQSO, your stock's cost basis is generally equal to the fair market value (FMV) at the time of the exercise (i.e. the cost basis is equal to the strike price of the NQSO of the option plus the ordinary income you realized – the "spread"). Using the correct cost basis ensures that you file correctly and aren't taxed more than the required amount.
Refer to Schwab's cost basis sheet to help you determine the cost basis on your stock plan transactions so you can file your taxes accurately. Generally, the cost basis can be found in Box 1e of your Form 1099-B, but this amount may need to be adjusted for the spread assessed as taxable compensation income in your W-2.
Stuck with questions? Call 800-654-2593 any time Monday through Friday to get answers to your equity award questions.
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The information and content provided herein is general in nature and is for informational purposes only. It is not intended, and should not be construed, as a specific recommendation, individualized tax, legal, or investment advice. Tax laws are subject to change, either prospectively or retroactively. Where specific advice is necessary or appropriate, individuals should contact their own professional tax and investment advisors or other professionals (CPA, Financial Planner, Investment Manager) to help answer questions about specific situations or needs prior to taking any action based upon this information.