Taxes on Non-Qualified Stock Options
Non-Qualified Stock Options (NSOs) do not come with the employee tax benefits of incentive stock options, the gains on which are generally taxed at lower capital gains rates. However, employers who offer NSOs receive key tax benefits; as a result, these options have become the preferred method for such grants, which come with a range of stipulations that affect the tax ultimately paid.
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Tax Basis
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When an employee exercises a non-qualified stock option, the difference (spread) between the price paid and the current market price is taxed at the same rate as ordinary income and must be declared on the tax return for that year. If the options are publicly traded, the tax is due on the grant date rather than the time of exercise, but this is not common. Once the option is converted to stock, the new tax basis becomes the market price on that date.
Capital Gains
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Employees have a choice after the option is exercised and they own the stock. If they hold it for more than a year and it appreciates in value, the gains are taxed at the long-term capital gains tax, which caps at 15 percent and is significantly lower than the top rate on ordinary income. If the shares are sold within 12 months, however, the gains are taxed at regular income rates. Any losses that result from the sale at a lower price than that on the date of exercise can offset other gains.
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Employer Incentives
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Employers generally prefer NSOs because they are permitted to take a tax deduction that comprises the difference between the price at which the stock is exercised and the then-current market value. The wider the spread, the bigger the potential tax savings, but this must be balanced against the tax consequences to prospective employees. Companies that grant such options are able to provide this potential benefit with no risk, and they also save the extra outlay of cash that may be required to attract key employees.
Employee Perspective
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The tax law outlines the parameters of how much may be due, but this is only relevant if the transaction is profitable. Employees are generally quite happy to pay the taxes in light of a tangible profit, and they have strong incentive to help contribute to a rise in the company's share price, especially if they take a longer-term perspective that may involve a higher stock price and lower taxes.
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