What Is the Tax Rate on Unqualified Options?

Employers like to grant stock options to retain and encourage valued employees. Unqualified options, also known as nonqualified or nonstatutory stock options, do not offer special tax advantages, but don’t let that bother you. If you're awarded unqualified stock options and your company’s stock does well, you stand to make money, perhaps a lot of it.

Description

Nonqualified options allow you to buy shares of company stock at a guaranteed exercise price. The exercise price usually is the same as or close to the market price at the time the options are awarded. If the price of the company’s stock goes up, you can exercise the options to buy shares and then sell them at the higher market price. Nonqualified stock options are usually good for several years. Companies typically require a waiting period before you can exercise them.

Bargain Element

Suppose you are awarded nonqualified options with an exercise price of $25 per share. A couple of years later the stock has risen to $35 per share, so you exercise your right to buy shares. The difference between the exercise price you pay and the market value on the day you exercise the options is $10 per share. The $10 difference is called the bargain element or compensation element. The IRS considers the bargain element compensation like your salary. In fact, your employer has to report the bargain element on your W-2 form. You pay Social Security tax, Medicare tax and income tax on the bargain element in the year of exercise. Your income tax rate is the highest tax rate that applies to your income. For example, if you're in the 28 percent tax bracket, the income tax rate on the bargain element is 28 percent.

Capital Gains

The market value on the day you exercise nonqualified stock options is considered your investment cost basis, because you paid the exercise price and taxes on the bargain element. If you choose to hold the shares, rather than sell them right away, you are likely to have a gain or loss when you eventually do sell them. This is a capital gain or loss. If it is a capital gain, it’s taxed at long-term or short-term capital gains rates, depending on how long you hold the shares. Losses are tax-deductible capital losses.

Considerations

Read the option agreement and ask questions so you know the exercise price and expiration date of your nonqualified options. Ask about waiting periods. Some companies stagger the waiting period so you can exercise only part of the options at a time. Finally, ask if the option agreement allows cashless exercise, an arrangement in which your broker loans you the exercise price. You buy the shares and deliver them to the broker, who sells them immediately. This arrangement lets you exercise the options without putting up the exercise price yourself.