To accurately plan cash flow, an employee must understand the tax treatment of exercising non-qualified stock options. Unlike with incentive stock options, simply exercising the option to purchase stock is an immediately taxable event in a non-qualified option. In addition, realization of a beneficial tax rate is affected by the employee’s choice about when to sell the acquired stock.
Immediate Taxable Amount
Upon the exercise of non-qualified stock options, an amount is taxed as ordinary compensation. Tax is assessed on the “bargain element," which is the difference between the option exercise cost and the market value of acquired stock. Tax treatment of the difference between sale proceeds and cost basis depends upon when the stock is sold.
Exercised and Held
The bargain element is taxed as compensation even if none of the stock is sold. If an employee does not sell enough shares to pay the tax liability on the bargain element, the tax must be paid from other resources. This bargain element is added to the cost of exercising the option to establish basis in the stock.
Sold in Exercise Year
Sale of the stock in the exercise year is a short-term capital gain or loss. The bargain element is taxed as ordinary compensation and added to basis. The capital gain is the difference between the sale proceeds and market value on the exercise date. If the bargain element is not added to the employee’s W-2, he must include it with compensation income on his personal tax return.
Sold Within One Year
Sale of the stock in the calendar year after exercise but before holding it for more than one year is a short-term capital gain or loss. The bargain element taxed as compensation in the preceding year is not included in the capital gain. Because the bargain element was added to basis, the capital gain is the sale proceeds minus the market value upon exercise.
Sold After One Year
Sale of the stock more than one year after exercise is a long-term capital gain or loss. If the stock is sold for a loss, the amount deductible against ordinary income in a single year is limited. Therefore, several years might be required for a deductible capital loss to offset the tax impact of the bargain element.