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.

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.

With NQSOs, taxes typically come into play twice—when you exercise the stock and when you sell shares.

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.

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.

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.

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.

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.")