Definition of Non-Qualified Stock Options
Stock options are a form of non-cash compensation employers offer by giving employees the option to purchase company stock at a specific price. The two basic types of stock options are qualified and non-qualified. When you exercise non-qualified options, any gains are not eligible for special tax treatment. This means you must count any gains as ordinary income, and the IRS taxes you at your ordinary income tax rate.
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Non-Qualified Versus Qualified
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When you exercise your non-qualified stock options, you receive company stock, and that could constitute a taxable event even if you do not sell the stock. If you buy and hold the stock after exercising your options, you must count the difference between the grant price and the current stock price as income. On the other hand, when you exercise your qualified stock options, the gains you make are eligible for special tax treatment, and you do not have to count any gains you make upon exercising your contract as income. If you sell the stock you received after exercising your contract, the IRS taxes any gains you make at the capital gains tax rate.
Calculating Gains
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To calculate the amount of additional income you received and the tax consequences resulting from exercising your stock options, you need to know the grant price and market price of the stock. The grant price is the specific stock price noted on your options contract, and the grant price typically is the price of the stock on the day your employer issues the employee stock ownership plan (ESOP) contract. The market price is the price of the stock on the day you exercise your options. For non-qualified stock options, if the stock's market price is higher than the grant price on the day you exercise your options, you trigger a taxable compensation event.
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Taxable Compensation
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The amount of taxable compensation for non-qualified stock option plans is the difference between the grant price and the market price on the day you sold your shares. For example, assume your non-qualified stock options contract has a grant price of $15, the market value on the day you sold your shares is $20, and you sell 200 shares. The taxable compensation is the difference between the grant price and the stock price, multiplied by the amount of sold shares. In this example it is $5 times 200 equals $1,000.
Selling Stocks
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If you exercise your stock options contract and hold the stocks for less than one year before selling them, the IRS taxes you at your regular income tax rate for any gains you made from exercising your contract as well as any gains on the sale of the individual stock. If you exercise your options and hold the stock for more than a year before selling, the IRS taxes you at your regular income tax rate for any gains you made upon exercising your contract. However, the IRS will tax you at the long-term capital gains tax rate for any gains you made from the sale of the stock.
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