Accounting for Nonqualified Options
The value of accurate accounting records for employees with options to purchase employer stock is apparent when the shares are purchased as well as when they’re sold. Nonqualified options are the right to purchase shares of company stock without qualifying for any special tax benefits. When the options are exercised, the stock is purchased and an immediate amount of taxable income is assessed. Employees who fail to account for that income risk being taxed again when they sell the stock.
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Compensation
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The exercise of nonqualified options results in an additional amount of ordinary compensation added to the employee’s annual W-2. This increases tax liability for that particular year. The taxable amount is the difference between the cost to purchase the stock and the stock value on the date of exercising the purchase option.
Basis
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Basis is a term for the amount of money used to acquire something. The basis for stock is normally the cost to buy it. Stock acquired from exercising nonqualified options has two components of basis. Like any asset that’s purchased, the basis of stock acquired from exercising an option includes the cost. In addition, basis increases by the amount taxed as compensation in the exercise year.
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Capital Gain
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The amount received for selling stock is taxable except for the part that equals basis. When stock is sold for more than the basis, a capital gain exists. Stock sold more than one year after option exercise is taxed at a favorable long-term capital gain rate. Sale of shares one year or less after option exercise is a short-term capital gain. A loss occurs if the stock sells for less than the basis. The maximum amount of capital loss deductible in a single year against other income sources is $3,000. Any excess is carried over to future years.
Sale Upon Exercise
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Selling stock upon exercise of nonqualified options provides cash to pay tax on the amount counted as compensation. Since the purchase date and sale date are the same, this is a short-term capital gain transaction. However, no gain is calculated because the sales proceeds and the basis are equal. The sale amount is the value upon exercise. The basis is the exercise cost plus the extra amount of value exceeding cost, which is taxed as compensation. Combined, they equal the total value upon exercise. Any commission for selling is deducted as a small loss.
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