FAQS
What are the U.S. federal tax effects of nonstatutory stock options?
- Operations
- Tax
There generally are no U.S. federal taxes due when a nonstatutory stock option (NSO) is granted, unless the NSO is granted with an exercise price less than the fair market value of the underlying stock on the date of grant, which is called a discount option. When the NSO is exercised after it vests, the optionee generally is taxed at ordinary income tax rates on the excess, if any, of the fair market value of the shares over the exercise price paid for the shares (the spread) at exercise.
An employee optionee generally is subject to tax withholding (federal and state income and employment taxes, and sometimes local taxes) on this spread at exercise and the income must be reported to the taxing authorities, unless the employee optionee timely files a Section 83(i) election (if eligible) with the IRS to defer the federal income taxes ordinarily due upon exercise. A non-employee optionee generally is subject to tax reporting, but not withholding. The company should be entitled to a deduction equal to the amount of ordinary income recognized by the optionee.
If the shares purchased through such exercise of the option are later sold or otherwise transferred, any gain or loss recognized by the optionee upon the sale or transfer of the shares generally will be treated as capital gain or loss, and such gain or loss will be long term or short term depending on whether the optionee has held the shares for more than one year after exercise.
NSOs that are discount options may result in unfavorable tax consequences for optionees, including additional taxes and earlier taxation. As a result, at the time of grant, it is critical to determine the fair market value of stock underlying an option according to the guidance issued by the IRS.
Bear in mind that the U.S. federal tax consequences (See FAQ: "What are the U.S. federal tax effects of early exercising a nonstatutory stock option") of early exercising an NSO to purchase unvested shares will be different from the consequences of exercising an NSO for vested shares as described above.
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