Nonqualified Stock Options

Nonqualified stock options are also known as non-statutory stock options. The difference between nonqualified stock options and both incentive stock options and options granted under an employee stock purchase plan is in how you report the income.

When you’re granted nonqualified stock options, you generally don’t need to recognize any income until you exercise them because you don’t have total control over the stock and the options will be lost if not exercised within the required time period. For more information, see IRS Publication 525: Taxable and Nontaxable Income. However, if the option has a readily determinable market value (that is, it is traded in an open market, such as the NY Stock Exchange), then you may have to recognize income when the option is granted.

When you exercise your options, you’ll have W-2 income equal to the difference between the fair market value (FMV) of the stock on the date that you exercised your options and the option price. Your employer will include that amount in box 1 of the W-2 form that they send you, and will enter the code "V" in box 12.

Because the difference between the option price and the fair market value on the date that you exercised your option is included in your W-2 income, you’ll have already paid taxes on it. The basis of the stock is the fair market value of the stock on the date that you exercised the options. (Amount you paid + Amount included in your income = Fair Market Value.)

As with qualified stock , you can often do a "paperless transaction" in which you exercise your NQSOs and sell the stock at the same time. Even though it seems as though you perform only 1 transaction, you need to think of it as 2 transactions -- you exercised your options and then you sold the stock.

Example

On December 15, 2007, your employer grants you an option to buy 100 shares of stock at $10 per share. You must use the options to purchase shares within a stated time period, so the options are restricted. On April 20, 2009, you exercise your options and purchase the 100 shares of stock. At the time you exercised your options, the fair market value of the stock was $16 a share. As a result of the transaction, your employer will include $600 in the income they report on your W-2:

$16 (FMV of the stock) - $10 (Price you paid for the stock) X 100 (Number of shares) = $600

The basis of your stock is $1,600 ($16 X 100 shares). On June 15, 2010, you sell the 100 shares for $23 per share, and receive a check for $2,300. As a result of the sale, you have a long-term capital gain of $700:

$2,300 (Total amount received from the sale) - $1,600 (Total basis of the stock) = $700

Now, let’s assume that you made a paperless transaction, and you exercised and sold your shares at the same time, on June 15, 2010. Your option is purchase 100 shares for is $10/share.  To exercise the option you work with a brokerage firm who pays the company on your behalf for the options and then credits your margin account for the sales proceeds. Accordingly, you need to report 2 transactions. The first is the exercise transaction. When you exercised the options, the fair market value of the stock was $23 a share. As a result of the transaction, the brokerage firm will pay $1,000 ($10 x 100 shares) directly to your employer and will credit your margin account with $2,300 ($23 x 100 shares) when you sell the shares. Your employer will then include $1,300 in the income that will be reported on your W-2:

$2300 (FMV of the stock x 100 share purchased) - $1000 (Option price) X 100 = $1,300

The second transaction is the gain or loss. In this case, there’s no gain or loss. The basis of your stock is $23 per share and you sold the stock for $23 per share. Note: Assume you paid $80 in brokerage fees on the sale. In this case, you will have a loss of $80:

$2,220 (Net proceeds) - $2,300 (Basis) = $80 loss.