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 tax overview helps you understand how your NQSOs are taxed and what documents you'll need when filing in the United States.

This guide provides general educational information about the U.S. federal tax rules applicable to NQSOs and the IRS forms to be filed. However, the tax rules are complicated, and this guide is not specific to any one individual taxpayer's circumstances, and it does not cover all situations. We recommend you discuss your specific situation with a tax professional before filing your return. The forms discussed in this guide are publicly available from the IRS; however, using a tax professional, or at minimum, tax preparation software, is recommended to make the tax preparation and filing process easier and to help avoid costly errors.

In this guide, we'll cover:

• When are NQSOs taxed?
• Tax document overview
• Tax reporting after you exercise options
• Reporting stock sales
• Completing your IRS tax forms

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.

At tax time, you'll use several forms to report capital gains and losses:

1. 1099-B reports the details of your stock sale.
2. Form 8949 and Schedule D use the information from 1099-B to calculate your capital gains and losses.

Here's an illustration to show how these documents work together when reporting stock sales:

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 the spread as 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.

Here's how your W-2 may look:

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.")

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.
 

Locate your cost basis information on your 1099-B form. The information can be found within the 1099-B section and the Realized Gain or (Loss) section of your 1099 Composite & Year-end statement. The cost basis price reported to the IRS (i.e., the award price) can be found under the 1099-B section, and your adjusted cost basis price or fair market value (FMV) can be found under the Realized Gain or (Loss) section. It is important to match transactions from the 1099-B section to the Realized Gain or (Loss) section when completing Form 8949.

On the sample form below, Schwab has indicated the areas to refer to when completing Form 8949.

Note: Do not use the information in this example. This sample form is not a full 1099 Composite statement, and Schwab has focused on the areas where stock plan transactions will be displayed for demonstrative purposes only.

The Realized Gain or (Loss) section of the 1099 Composite statement will contain the FMV you'll use on Form 8949 to adjust the cost basis. The adjusted cost basis will include the income portion. This is extremely important, as the tax on the income portion will be included on your W-2. In the example form below, Schwab has indicated important areas you'll need to refer to when completing your taxes.

Follow the IRS instructions for completing Form 8949 to adjust the cost basis on covered securities, then complete Schedule D with the totals from Form 8949.

Form 8949 requires the details of each capital asset transaction and helps you calculate capital taxes due. It includes two parts to separate short-term capital gains and losses from long-term gains and losses because they are subject to different tax rates.

Schedule D reports your capital gains or losses and the corresponding taxes due. The calculations from Schedule D are combined with your tax return Form 1040 and affect your adjusted gross income amount.