One way to reward employees
One strategy companies use to reward employees is to give them options to purchase a certain amount of the company’s stock for a fixed price after a defined period of time. The hope is that by the time the employee’s options vest—that is, at the time the employee can actually exercise the options to buy stock at the set price—that the market price of the stock will have risen, so the employee gets the stock for less than the current market price.
If you’re an executive, some of the options you receive from your employer may be Non-qualified Stock Options. These are options that don’t qualify for the more-favorable tax treatment given to Incentive Stock Options. In this article, you’ll learn the tax implications of exercising non-qualified stock options.
Let’s assume that you receive options on stock that is actively traded on an established market such as the NASDAQ, but that the options themselves aren’t traded. The tax catch is that when you exercise the options to purchase stock (but not before), you have taxable income equal to the difference between the stock price set by the option and the market price of the stock. In tax lingo, that's called the compensation element.
Compensation element
The compensation element is basically the amount of discount you get when you buy the stock at the option exercise price instead of at the current market price. You calculate the compensation element by subtracting the exercise price from the market value.
- The market value of the stock is the stock price on the day you exercise your options to buy the stock. You can use the average of the high and low prices that the stock trades for on that day.
- The exercise price is the amount that you can buy the stock for according to your option agreement.
And here’s the kicker: Your company must report the compensation element as an addition to your wages on your Form W-2 in the year you exercise the options. This means the IRS knows all about your windfall, and treats it as, compensation income, just like your salary. You will owe income tax and Social Security and Medicare taxes on the compensation element.
When do I have to pay taxes on my options?
First things first: You don’t have to pay any tax when you’re granted those options. If you are given an option agreement that allows you to purchase 1,000 shares of company stock, you have been granted the option to purchase stock.
This grant by itself isn’t taxable. It’s only when you actually exercise those options and when you later sell the stock that you purchased that you have taxable transactions.
How you report your stock option transactions depends on the type of transaction. Usually, taxable Non-qualified Stock Option transactions fall into four possible categories:
- You exercise your option to purchase the shares and you hold onto the shares.
- You exercise your option to purchase the shares, and then you sell the shares the same day.
- You exercise the option to purchase the shares, then you sell them within a year or less after the day you purchased them.
- You exercise the option to purchase the shares, then you sell them more than a year after the day you purchased them.
Each of these four scenarios has its own tax issues as the following four tax examples show.
1. You exercise your option to purchase the shares and hold onto them.
In this situation, you exercise your option to purchase the shares but you do not sell the shares.
| Exercise date: | 6/30/2024 |
Exercise price: | $25 |
Market price on 6/30/2024 | $45 |
| Sales price | N/A (not sold yet) |
Number of shares: | 100 |
Your compensation element is the difference between the exercise price ($25) and the market price ($45) on the day you exercised the option and purchased the stock, times the number of shares you purchased.
- $45 − $25 = $20 x 100 shares = $2,000
- $20 × 100 shares = $2,000
Your employer includes the compensation element amount ($2,000) in Box 1 (wages) of your 2024 Form W-2. Why is it reported on your W-2? Because it’s considered “compensation” to you, just like your salary. So even though you haven’t yet seen any actual profit from selling the shares, you’re still taxed on the compensation element just as if you had received a $2,000 cash bonus.
What if for some reason the compensation element is not included in Box 1? It’s still considered part of your wages, so you must add it to Form 1040, Line 7 when you fill out your tax return for the year you exercise the option.
2. You exercise your option to purchase the shares and then sell them the same day.
| Exercise date: | 6/30/2024 |
| Exercise price: | $25 |
| Market price on 6/30/2024: | $45 |
| Sales price on 6/30/2024: | $45 |
| Commission paid on sale: | $10 |
| Number of shares: | 100 |
As in the previous example, the compensation element is $2,000, and your employer will include $2,000 in income on your 2024 Form W-2. If they don't, you are required to add it to Form 1040, Line 7 when you fill out your 2024 tax return.
Next, you have to report the actual sale of the stock on your 2024 Schedule D, Capital Gains and Losses, Part I.
Because you sold the stock right after you bought it, the sale counts as short-term (that is, you owned the stock for a year or less—less than a day in this case). In this example, the date acquired is 6/30/2024 and the date sold is also 6/30/2024.
Then you have to determine if you have a gain or loss. In this example, the cost basis of your shares is $4,500, and the sales price is $4,490. The $10 (from the commission),is your short-term capital loss. How did we determine these amounts?
- The cost basis is your original cost (the value of the stock, consisting of what you paid, plus the compensation element that you have to report as compensation income on your 2024 Form 1040). The cost basis is therefore, is the actual price paid per share times the number of shares ($25 x 100 = $2,500) plus the $2,000 of compensation reported on your 2024 Form W-2. Therefore, the total cost basis of your stock is $4,500 ($2,500 + $2,000).
- The sales price is the per-share market price on the date of sale ($45) times the number of shares sold (100), which equals $4,500. Then, you subtract any commissions paid for the sale ($10, in this example) to arrive at $4,490 as your final sales price. You’ll probably receive a 2024 Form 1099-B from the broker that handled your option purchase and sale. That form should show $4,490 as your proceeds from the sale.
- Subtracting your sales price ($4,490) from your cost basis ($4,500), you get a loss of $10.
Remember, you actually came out well ahead (even after taxes) since you sold stock for $4,490 (after paying the $10 commission) that you purchased for only $2,500.
3. You exercise the option to purchase the shares and then sell them within a year or less after the day you purchased them.
| Exercise date: | 6/30/2024 |
| Exercise price: | $25 |
| Market price on 6/30/2024: | $45 |
| Sales date: | 12/15/2024 |
| Sales price: | $50 |
| Commission paid at sale: | $10 |
| Number of shares: | 100 |
Again, the compensation element of $2,000 (calculated as in the previous examples) is considered taxable income and should be included in Box 1 of your 2024 Form W-2. If not, you must add it to Form 1040, Line 7 when you fill out your 2024 tax return.
Because you sold the stock, you must report the sale on your 2024 Schedule D.
The stock sale is considered a short-term transaction because you owned the stock less than a year. In this example, the date acquired is 6/30/2024, the date sold is 12/15/2024, the sales price is $4,990, and the cost basis is $4,500. The short-term capital gain is the difference of $490 ($4,900-$4,500). How did we get these figures?
- The sales price ($4,990) is the market price at the date of sale ($50) times the number of shares sold (100), or $5,000, less any commissions you paid when you sold it ($10). The Form 1099-B from the broker handling your sale should report $4,990 as the proceeds from your sale.
- The cost basis is the actual price you paid per share times the number of shares ($25 × 100 = $2,500), plus the compensation element of $2,000 for a total of $4,500. So, the gain is $490, the difference between your basis and the sales price, and will be taxed as a short-term capital gain at your ordinary income tax rate.
4. You exercise the option to purchase the shares, then sell them more than a year after the day you purchased them.
| Exercise date: | 06/30/2020 |
| Exercise price: | $25 |
| Market price on 6/30/2020 | $45 |
| Sales date: | 12/15/2024 |
| Sales price: | $50 |
| Commission paid at sale: | $10 |
| Number of shares: | 100 |
The compensation element of the $2,000 is the same as in the preceding examples and should have appeared in Box 1 of your W-2 for 2020 (the year you exercised the options to purchase the stock.) Because this transaction occurred in a previous year, you don’t have to pay tax on the compensation element again; it’s now considered part of your cost basis purchase price for the stock.
You then must report the sale of the stock on your 2024 Schedule D, Part II because it’s a long-term transaction; you owned the stock for almost 18 months. As in the preceding example, the stock sale gain is $490, calculated in the same manner ($4,990 sale price - $4,500 cost basis). But now the $490 gain is a long-term gain, so you only have to pay tax at the capital-gains rate, which will probably be a lot lower than your regular income-
Things to remember when granted stock options
When you are granted non-qualified stock options, get a copy of the option agreement from your employer and read it carefully. Your employer is required to withhold payroll taxes on the compensation element, but occasionally that doesn’t happen correctly.
In one case we know of, an employee’s payroll department did not withhold federal or state income taxes. He exercised his options by paying $7,000 and sold the stock on the same day for $70,000 then used all the proceeds (plus additional cash) on the deal, to buy an $80,000 car, leaving very little cash on hand. Come tax return time the following year, he was extremely distressed to learn that he owed taxes on the compensation element of $63,000. Don’t let this happen to you.
Employers must report the income from a 2024 exercise of Non-qualified Stock Options in Box 12 of the 2024 Form W-2 using the code “V.” The compensation element is already included in Boxes 1, 3 (if applicable) and 5, but is also reported separately in Box 12 to clearly indicate the amount of compensation arising from a non-qualified stock option exercise.
For more information, see IRS Publication 550: Investment Income and Expenses (Including Capital Gains and Losses) and the Stock Options section in IRS Publication 525: Taxable and Nontaxable Income.
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