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.
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The option is transferable by the optionee.
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The option is exercisable immediately in full by the optionee.
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Neither the option, nor the underlying property is subject to any restrictions
that have a significant effect on the option's value.
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The fair market value of the “option privilege” is readily ascertainable.
Thus, valuation of the option privilege requires a prediction of the future
course of the underlying property's value, something that is often impossible
to do with reasonable accuracy. This one requirement alone effectively
denies readily ascertainable fair market value status at grant to most
options.
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.
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If the underlying property is not restricted when you exercise the options,
compensation income is computed as the difference between the fair market
value at date of exercise and date of the grant. The effect of not having
a taxable event at the time of grant is to treat as compensation income,
and not capital gain, the appreciation in the value of the property underlying
the option between option grant and exercise. When you sell the stock,
the basis in the stock will equal the sum of the exercise price plus the
amount included in ordinary income at exercise.
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If the underlying property is restricted at exercise, you postpone the
taxable event with respect to the options exercise until the restrictions
lapse. However, you can make a §83(b) election within 30 days after
the transfer of the property. This essentially closes the taxable event
at exercise and provides an opportunity to limit ordinary income from the
transaction to any difference on the date the property is transferred between
the fair market value and the amount paid for the property. Any appreciation
in the property after the date of transfer is converted into capital gain
income.
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:
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Your name, address and identification number (Social Security number);
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Description of each property for which the election is being made;
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Date (or dates) when the property was transferred, and the taxable year
for which such election was made;
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Nature of restriction or restrictions on the property;
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Fair market value of property (determined without considering any restriction
other than one which will never lapse) at the time of transfer;
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Amount of consideration paid for the property; and
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Statement that required copies have been provided.
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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