By: AnnaMarie Mock, CFP®
As we head into the throes of tax season, investors will be getting a slew of tax documents to report on their tax returns. Tax filing can be complicated even further by adding equity compensation into the equation because there can be (1) multiple tax reporting forms for one transaction, (2) different tax treatments based on the type of compensation (3) specific rules for varying strategies.
This article will focus on only one type of equity compensation, non-qualified stock options (NQSOs), to make the information digestible.
What are Non-qualified Stock Options (NQSOs)?
Like restricted stock units (RSUs) and incentive stock options (ISOs), NQSOs provide an alternate form of compensation that attracts and retains employees. NQSOs give employees the right to buy company shares at a preset price (strike price) when the options vest. Generally, there is no tax recognition at the grant unless an 83(b) election is made.
When Should NQSOs be Exercised?
Exercise NQSOs when the exercise price (current price per share) exceeds the strike price, also referred to in the money. When NQSOs are exercised in the money, the difference between the exercise and strike prices is taxed as ordinary income.
If the exercise price is below the strike price, the option is considered out of the money. You can wait for the price to surpass the strike price or expire at this juncture.
Exercise Price = $25 (In the Money)
Strike Price $15 ---------------------------------------------------------------------------------------
Exercise Price = $5 (Out of the Money)
For example, Maggie exercises 100 vested shares at a strike price of $15 with an exercise price of $25 per share. Her NQSOs are in the money because the exercise price is greater than the strike price. She pays $1,500 for stock valued at $2,500, and the gain of $1,000 is taxed as ordinary income and reported on Form w-2 and Form 1099-Misc.
What are the Tax Implications if the Stock is Retained after Exercising?
The FMV at exercise becomes the cost basis, which is pertinent when calculating the taxable gain at the sale.
Continuing Maggie’s example from above, her cost basis is $2,500 after exercising and paying the tax on the bargain element. The timing and FMV at the sale will dictate the amount of taxes.
Sells The Same Day: If she sells the 100 shares simultaneously as exercising, there should be no gain or loss because the sale price would match the fair market value. The bargain element would still be taxed as ordinary income because this is separate from the sale.
Sells Within a Year: If she sells the 100 shares within a year of exercising, any gain is taxed as a short-term capital gain (ordinary income tax rates).
Sells After a Year: If she sells the 100 shares within a year of exercising, any gain will be taxed as long-term capital gain (preferential long-term capital gains rate).
In the year of the sale, Maggie will receive Form 1099-B with all the details regarding the transaction, which will be reported on Schedule D - Form 1040 and Form 8949.
Tax Tips for NQSOs?
It is not uncommon for the cost basis reported on Form 1099-B from a sale to be incorrect. It’s advisable to double-check the numbers through a simple calculation: adding up the exercise value and bargain element to get the cost basis.
The sum gets reported on Form 8949, where it has sections for the reported cost basis provided on Form 1099-B and any adjustments to the basis. By doing this, you are avoiding double taxation.
Managing and tracking stock options is complicated enough by itself! Working with an accountant and fiduciary advisor will eliminate the guesswork by creating a plan to smooth out cash flow and taxes while coordinating the benefits.
AnnaMarie Mock is a CERTIFIED FINANCIAL PLANNER™ and Partner at HIGHLAND Financial Advisors, LLC, a Fee-Only financial planning firm that offers comprehensive financial planning, retirement planning, employer retirement planning, and investment management. AnnaMarie graduated from Montclair State University with a degree in finance and management and successfully passed the CFP® national exam in 2016. She has been working at Highland Financial Advisors since 2013 as a fee-only, fiduciary Wealth Advisor and is a member of NAPFA.