The tax treatment of nonqualified stock options (NSOs) is quite simple. Unfortunately, filling out the IRS forms can be complicated — especially since recent rule changes went into effect. Here are four things you should know about NSOs.
1. How NSOs work
An NSO is an option that doesn’t qualify for the special tax treatment afforded incentive stock options (ISOs). Despite the potential tax advantages of ISOs, most employers use NSOs because they’re simpler, their tax treatment is more straightforward, and they avoid certain risks and limitations associated with ISOs.
Let’s look at an example: ABC Inc. grants its employee, Steve, NSOs to buy 100 shares of the company’s stock for $100 per share — the fair market value (FMV) on the grant date. The options vest over five years and must be exercised within 10 years. In year 5, the stocks’ FMV has increased to $150 per share, and Steve exercises all of his options, buying shares worth $15,000 (100 × $150) for $10,000 (100 × $100).
2. NSO tax treatments
Generally, there are no tax consequences when NSOs are granted. Publication 525’s discussion of NSOs devotes several paragraphs to the circumstances under which an option grant requires you to report taxable income. This would be the case if the option itself (as opposed to the underlying stock) has “readily determinable value.” But options granted by employers almost never satisfy this requirement.
When you exercise an NSO, however, you must report compensation income equal to the spread between the exercise price and the stock’s FMV on the exercise date. Going back to the example, when Steve exercises his options, he receives $5,000 in compensation, which is taxable to him as ordinary income and deductible by his employer. It’s included in wages on Steve’s Form W-2 and is subject to payroll taxes. In the case of a nonemployee, income from the exercise of NSOs would be reflected on Form 1099-MISC.
3. Basis for confusion
Reporting income on the exercise of NSOs is a no-brainer. So long as the amount is reported properly on your W-2 or 1099-MISC, it should appear correctly on your tax return. Things get a bit more complicated, however, when you sell the stock. In theory, calculating and reporting gain on the sale of option stock is simple: You take the proceeds from the sale (net of any broker’s commissions or other expenses) and subtract your basis in the stock.
The difference is short- or long-term capital gain, depending on how long you held the stock. Generally, the basis is equal to the amount you paid for the shares (the exercise price) plus the amount of compensation income you reported upon exercise.
Suppose Steve, from the example above, holds his stock for two years and sells it for $18,000. His basis is $15,000 — the original exercise price of $10,000, plus the $5,000 he reported as wages. When he sells the stock, he will recognize $3,000 in long-term capital gain.
But, here’s the problem: When you sell stock your broker sends you a Form 1099-B and files it with the IRS. The form reports your proceeds from the sale and may also report your basis. But when a 1099-B relates to stock acquired through the exercise of NSOs, there’s a good chance the basis amount is wrong.
The 1099-B instructions state, “If the securities were acquired through the exercise of a compensatory option, the basis hasn’t been adjusted to include any amount related to the option that was reported to you on a Form W-2.” But this may or may not be true.
Until recently, brokers were permitted, but not required, to adjust basis to reflect the amount of compensation income reported when options were exercised. For options granted after 2013, however, brokers are prohibited from making this adjustment. That means that, for options granted in 2014 or later, the basis entered on Form 1099-B will definitely be wrong — so you’ll need to adjust it yourself. For options granted earlier, brokers are still permitted to make the adjustment, so you’ll need to calculate the basis yourself to ensure you report the right amount of gain.
Do your homework
If you sell stock acquired through the exercise of NSOs, don’t rely on the basis reported by your broker. If you do, and the basis wasn’t adjusted, you’ll overstate your gain (or understate your loss) and overpay your taxes. Determine the basis yourself and, if the amount in your 1099-B is wrong, correct it in your tax return.