To help clear up the issue, I am providing a brief overview of the taxation of Nonqualified Stock Options (NSOs), one of the most common forms of equity compensation I see in practice.
Step 1: Grant Documents
Administering stock option equity compensation begins when the employing company issues a grant for the option to the employee or contractor.
An option represents the right to acquire a share of stock at a specified price on or before a particular date. There are no tax consequences upon the grant of a NSO.
When issuing grants, the company should provide you with a Grant Document. It is crucial that you provide this document with your tax advisor. The grant document will detail:
Step 2: Vesting
Once a grant has been given, the next event is that your NSOs will begin to vest according to the schedule detailed in your grant document. While a grant is an ironclad arrangement allowing you to purchase a certain volume of stock at a certain price, you do not have access to the shares until your options vest. Vesting is not a taxable event.
Step 3: Exercising Your Options
Following vesting, you now have the opportunity -- but not the obligation -- to exercise your shares at the price specified in the grant document. This action means you have now purchased the volume of shares at the agreed-upon price.
For NSOs, exercise is the trigger event that results in taxable income.
Step 4: Taxation on Exercise
Once you exercise your shares, you will be subject to taxation based on the difference in value between the stock price at the point of exercise compared to the agreed-upon grant price (see the examples 1 and 2).
At the point of exercise, your tax advisor will need to know the following details in order to properly determine taxable income:
Because the tax effects for NSOs are delayed in this way, many employees receiving them get caught off guard when trying to manage their tax burden. For this reason, it is critically important that you speak with a tax advisor upon creating an NSO arrangement. That way, you can prepare and strategize in the long-term for the eventual gains you will create.
To help you understand how taxation works with NSOs and how you might minimize your tax burden, consider the two examples.
Example 1 - Fully Vested Sale
You are granted 1,000 shares with a fair market value of $1, and an exercise price of $1. The vesting schedule is a 1 year cliff*, followed by 1/48 per month thereafter. 4 years later, you exercise all of your shares. At that point, the fair market value is $4 per share. The tax implications of this transaction are as follows:
*1 year cliff = one quarter of the shares vest after one year (250 shares in this example)
**The ordinary income is reported on a W-2 for an employee or a 1099 for an advisor
The total value of the shares is now $4,000, which is your new tax basis in those shares. This means that when you eventually sell the shares, the cost will be $4 per share.
Example 2 - Early Exercise, 83(b) Filed
Using the same grant details as above, you decide to exercise all of your shares after one year when 250 shares have vested, and the FMV of those shares is $3. In this situation, an 83(b) election can be filed.
Only 250 shares are actually owned, but you have paid tax on 1,000 shares. If you hold all of the shares to vesting and the FMV increases, no additional tax is due on ordinary income. Instead, the increase in value will be taxed at more favorable rates as long term capital gain.
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CPA + Partner at Why Blu