Taxation of Non-qualified Stock Options
Non-qualified stock options are not taxable until exercised. Upon exercise, assuming you are vested (or have filed an 83(b) election—a topic for a future post), you must report the bargain element as compensation income. You may recall from a prior post that the bargain element is equal to the current FMV less the strike price. Since the bargain element of NQSOs is considered compensation income, your company will report it on your W2 and withhold income tax, social security, and medicare. When you eventually sell the stock (same-day or years later) you will have a capital gain or loss determined by taking the eventual sale price and subtracting your basis (what you paid for the stock plus the amount reported as compensation income).
For example, if you were granted non-qualified stock options with a strike price of $2 per share and the FMV at time of exercise is $10 per share, your taxable compensation income will be $8 per share. Regardless of whether you immediately sell the stock or hold it, you will pay income tax, social security, and medicare on $8 per share. When you eventually sell the stock you will have a capital gain or loss based on the difference between the sale price and your basis of $10 per share ($2 exercise + $8 compensation income). If the sale occurs within one year from the date of exercise it will be considered short-term and subject to ordinary income rates, and if you wait more than one year it will be taxed at the lower long-term rates.
When it comes to personal record-keeping, non-qualified options should be pretty easy. Your company is responsible for reporting the compensation income at exercise on your W2 and any subsequent capital gains or losses should be reported on a 1099 from the broker or custodian where your shares are held and sold.
An important note about risk: If your company is public at the time you exercise non-qualified stock options and you’re not subject to any restrictions (e.g. lock-up or black-out) you need to consider carefully whether it makes sense to continue holding the stock. From a tax standpoint, holding stock from exercised NQSOs is no different than getting a cash bonus and buying the stock on the open market. In other words there is no tax incentive, but you will bear significant concentration risk by holding a single stock instead of a diversified portfolio.