Nonqualified Stock Options




 

Tax Consequences of Nonqualified (Nonstatutory) Stock Options


Internal Revenue Code Section 83 governs nonstatutory stock options. Nonstatutory stock options trigger ordinary income to you at some point in time and produce a compensation deduction to the employer. §83 contains two rules affecting all nonstatutory stock option transactions. In the following circumstances, all stock options are considered not actively traded on an established market. Taxation at Grant (1) §83 will apply to the grant of a nonstatutory stock option only if the option has a readily ascertainable fair market value at the time of its grant. Nonstatutory stock options must meet four conditions to have a readily ascertainable fair market value.

Treatment: Assuming the above four conditions are met, the fair market value less any amount paid for the option will be taxed in the taxable year of the grant and treated as compensation income (ordinary income). There is no tax consequence upon the exercise of the option. Upon sale of the stock, you will realize capital gain. The amount of the gain will be the selling price reduced by the basis in the stock. Basis will equal the sum of the per share amount paid for the exercise of the option and any amount included in income upon the options grant. Taxation at Exercise (2) §83 will apply to the transfer of property pursuant to the exercise of a nonstatutory stock option only if the option did not have a readily ascertainable fair market value at its grant. Treatment: There is no taxable event at date of the grant. The employer will receive a deduction in the year in which the employee's income inclusion ends. For example, the deduction is allowed either (1) in the employer's year that ends with the employee's year (i.e., the employer and the employee use the same taxable year); or (2) in the employer's year in which the employee's year ends (i.e., if the employee and the employer use different taxable years). Generally, the employer's deduction is the same amount included in
ordinary income by the employee; however, the employer's deduction can be limited in certain instances.

Under both rules above, the holding period for property acquired in a §83 transaction begins with the date on which the property becomes taxable as compensation income. The following maximum marginal tax rates are currently in effect:
 

Holding period Maximum marginal tax rate
12 months or less 39.6%
More than 12 months 20.0%

The income arising in nonstatutory stock option transactions under §83 triggers the receipt of wages for purposes of withholding tax. The obligation to pay employment taxes and to withhold income taxes generally belongs to the employer. The employer will more than likely withhold FICA, Medicare and withholding from other cash compensation paid to you.


Frequently Asked Questions

 

Q1. Will the grant of a Nonstatutory Option result in Federal income tax liability to me?

A1. Generally, no. However, if the option has a readily ascertainable fair market value at the time of its grant, the answer is yes.
 

Q2. Will the exercise of a Nonstatutory Option result in Federal income tax liability to me if the option does not have a readily ascertainable fair market value at the date of grant?

A2. Generally, you will recognize ordinary income in the year in which you exercise the nonstatutory option. The ordinary income amount will be equal to the excess of (i) the fair market value of the purchased shares on the exercise date over (ii) the exercise price paid for those shares. Your employer will report this income on your W-2 wage statement for the year of exercise or on a Form 1099 if you are not an employee. You will be required to satisfy the tax withholding requirements applicable to this income.
 

Q3. What if the shares purchased under a Nonstatutory Option are subject to a substantial risk of forfeiture?

A3. There are times when the shares you purchase under a Nonstatutory Option are subject to a substantial risk of forfeiture. For example, the Corporation's right to repurchase those shares at the original exercise price upon your termination of service before vesting in such shares, is a substantial risk of forfeiture. As such, you will not recognize any taxable income at the time of exercise. You must report as ordinary income, as and when the Corporation's repurchase rights lapse, an amount equal to the excess of (i) the fair market value of the shares on the date such shares vest over (ii) the exercise price paid for the shares. If you purchase shares subject to a substantial risk of forfeiture, you may elect under Section 83(b) to recognize income at the time of exercise. If a Section 83(b) election is made, you will not recognize any additional income with respect to your shares until you sell or otherwise transfer such shares in a taxable transaction. See Q4.
 

Q4. What is the effect of making a Section 83(b) election?

A4. If you purchase shares subject to a substantial risk of forfeiture, you may elect under Section 83(b) to recognize ordinary income in the year of exercise. The ordinary income amount is equal to the excess of (i) the fair market value of the purchased shares on the exercise date over (ii) the exercise price paid for the shares. The fair market value of the purchased shares will be determined as if the shares were not subject to the substantial risk of forfeiture. If you make the Section 83(b) election, you will not recognize any additional income when the forfeiture risk subsequently lapses.

You must file the Section 83(b) election with the Internal Revenue Service within thirty (30) days following the date the option is exercised, and any ordinary income resulting from such election will be subject to applicable tax withholding requirements.
 

Q5. What information must be included in a Section 83(b) election?

A5. The election is made by filing two copies of a written statement with the IRS Service Center where you file your return - one at the time of the election and one with the tax return for the tax year in which the property was transferred. You must also give a copy of the written statement to your employer, or the person for whom you performed services. The following information must be included in the Section 83(b) election:

Q6. Will I recognize additional income when I sell shares acquired under a Nonstatutory Option?

A6. Yes. You will recognize a capital gain to the extent the amount realized upon the sale of such shares exceeds their fair market value at the time you recognized the ordinary income with respect to their acquisition. A capital loss will result to the extent the amount realized upon the sale is less than such fair market value. The gain or loss will be long-term if you hold the shares for more than one (1) year prior to the disposition. The holding period normally starts at the time the Nonstatutory Option is exercised. If you purchase shares subject to a substantial risk of forfeiture, the capital gain holding period will start either: (i) at the time the shares may first be sold free of forfeiture risk, if no Section 83(b) election is made at the time of exercise of the option, or (ii) at the time the option is exercised if you file the Section 83(b) election within thirty (30) days after the exercise date.
 

Q7. What are the Federal tax consequences to the Employer

A7. The employer will receive a deduction in the year in which the employee's income inclusion ends. For example, the deduction is allowed either: (1) in the employer's year that ends with the employee's year (i.e., the employer and the employee use the same taxable year); or (2) in the employer's year in which the employee's year ends (i.e., if the employee and the employer use different taxable years). Generally, the employer's deduction is the same amount included in ordinary income by the employee; however, the employer's deduction can be limited in certain circumstances. If the deduction is attributable to a nonstatutory option exercised for shares subject to a substantial risk of forfeiture, then without a Section 83(b) election, the deduction will not be allowed until the taxable year of the employer which includes the last day of the calendar year in which you recognize the ordinary income with respect to the shares acquired under your nonstatutory option.


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