Nonqualified Stock Options

Nonqualified stock options are also known as non-statutory stock options. They’re stock options that the tax code doesn’t have any special rules for. 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 first need to determine whether or not the stock options are traded on the open market (the NYSE or similar market). If they are, then you need to recognize income from the grant. This means that when your company granted you the options, they included the income on your W-2 form. To calculate the amount to include in your W-2 income, your company multiplied the option price by the number of options granted. This is a rare situation.

If the stock isn’t traded publicly or it’s restricted in some way (you don’t have total control over the options), then you don’t need to recognize any income until you exercise them. 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. If you don’t have total control over the stock and there’s a chance that you’ll have to forfeit some of it, this might not occur until some time after you’ve exercised your options. For more information about these less common situations, see IRS Publication 525, Taxable and Nontaxable Income.

Since 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.

With nonqualified options, you can often do a "paperless transaction." You exercise your options and sell the stock at the same time. Even though you perform only one transaction, you need to think of it as two transactions—you exercised your options and then you sold the stock.

Example

On December 15, 2005, your employer offers to let you buy 100 shares of stock at $10 per share. You must use the options to purchase shares of the company from the company, otherwise the options are restricted. On April 20, 2006, you exercise your options and purchase the 100 shares of stock. At the time of 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, 2007, 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, 2007. Although you made only one transaction, you need to treat it as two transactions. The first is the exercise. When you exercised the options, the fair market value of the stock was $23 a share. As a result of the transaction, your employer will include $1,300 in the income they report on your W-2:

$23 (FMV of the stock) - $10 (Option price) X 100 (Number of shares) = $1,300

The second part of the 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.