Taxes on Non-Qualified Stock Options (NSOs)

Tax Overview for Non-Qualified Stock Options (NSOs)

• NSOs are tax-free at the granting and vesting stages.

• Exercising your non-qualified stock options creates a taxable event, but you can manage it by deciding when to exercise.

Two taxes to consider for your non-qualified stock options

• Earned income is taxed as ordinary income and is subject to Social Security and Medicare wage taxes.

• Capital gains are taxed as (a) ordinary income or as (b) long-term capital gains, depending on the holding period of the stock.

How am I taxed when I exercise your non-qualified stock options?

• When you exercise non-qualified stock options, the difference between the Fair Market Value (FMV) and the strike price (this is called the “bargain element”) is treated as earned income and is reported on your tax return. It should also show up in your W-2 statement.

• There are two types of taxes on earned income:

  • Social Security/Medicare taxes (also known as "FICA” or "payroll taxes")

  • Income taxes (Both Federal and State)

• If you exercise 2,000 NSOs with a strike price of $10/share when the FMV = $20/share —> Bargain Element = $20,000

• We need to keep track of the cost basis as it is necessary to calculate capital gain/loss upon a subsequent sale of the exercised stock. The cost basis after exercise = 2,000 shares x $20/share = $40,000

What are the tax consequences when I sell my stocks (from NSOs)?

After exercising, you can either sell immediately or hold. Your holding duration impacts taxation:

• Short-term (less than a year) capital gains are taxed at ordinary rates.

• Long-term (more than a year) capital gains will likely be taxed at long-term rates.

Planning opportunities

1. Early Exercise: Exercising NSOs before they vest, if allowed by the company, can be a strategy to initiate the clock for long-term capital gains earlier. By paying the exercise price and taxes on the intrinsic value early, the hope is that the stock will appreciate over time, and when it's eventually sold, most of the gains will be taxed at the more favorable long-term capital gains rate.

2. Tax Bracket Management: By strategically deciding when to exercise NSOs, you can manage your taxable income to stay within a desired tax bracket, especially if you anticipate fluctuating income or expect to be in a higher tax bracket in future years.

3. Alternative Minimum Tax (AMT) Planning: Though NSOs themselves don't trigger AMT (like Incentive Stock Options or ISOs do), if you're also exercising ISOs in the same year, you might want to exercise some NSOs to generate ordinary income, which could offset some AMT liability.

4. Diversification: If a substantial percentage of your net worth is tied up in your company's stock, you may consider selling some of your shares post-exercise to diversify your portfolio and reduce company-specific risk.

5. Charitable Giving: If you're charitably inclined and have appreciated company stock from exercised NSOs, consider donating the stock directly to a charity or a donor-advised fund. You could potentially receive a tax deduction for the full market value while avoiding capital gains tax on the appreciation.

6. Stock Loan Programs: Some financial institutions offer stock loan programs, allowing you to borrow against your company stock's value after exercising your NSOs. This can provide liquidity without triggering a taxable event.

7. Qualified Small Business Stock (QSBS): While NSOs themselves don't qualify for QSBS tax treatment, if you exercise NSOs in a company that is a qualified small business, and you hold the stock for more than five years, you might qualify to exclude a significant portion (potentially up to $10 million or 10 times your basis, whichever is greater) of your gains from federal taxation when you sell. It's crucial to understand the requirements and limitations of QSBS.

8. Financial Modeling: Use financial modeling to project the potential outcomes of different exercise strategies, considering stock price appreciation, taxes, and other financial goals.

Take action

Navigating Non-Qualified Stock Options can be complex, but they offer incredible opportunities to maximize your wealth. If you hold NSOs, don't let them sit idly. Let's dive deep together and chart a strategic roadmap tailored for your unique financial landscape.

Why not schedule a Zoom chat with me? I specialize in NSO planning and have empowered numerous clients to make informed decisions around their stock compensation. Together, we can clarify the nuances, strategize your next moves, and ensure you're fully harnessing the power of your NSOs.