IRS Taxation of Nonqualified Stock Options (NQSOs)

What are Nonqualified Stock Options (NQSOs)?

A Nonqualified Stock Option “NQSO” is any option that is not a qualified stock option. Unlike Incentive Stock Options (ISO) holders who meet the required holding period, the recipient of an NQSO is not allowed either to defer income recognition on the bargain element until the stock is sold or to have all the income associated with the option treated as capital gain. This basically means that they must pay taxes on the amount the is realized.

 

How are Nonqualified Stock Options (NQSOs) taxed?

Generally, the excess of the stock’s FMV when the option is exercised over the option price is taxable as compensation in the year of exercise. However, if the FMV of the option is readily ascertainable when the option is granted, income will be recognized then rather than when the option is exercised. From an employee’s perspective, this may be the most advantageous time for income recognition if the stock value increases significantly after the option is granted.

Taxation of Option Transfers

Unfortunately, if the option is not traded, it can be difficult to determine whether the option has a readily ascertainable FMV. An option does not have a readily ascertainable FMV unless the following conditions are met:

 

Taxing NQSOs

1. The option may be transferred freely.

2. The option is exercisable immediately in full.

3. There are no restrictions on the option or stock that have a significant effect on the FMV of either.

4. The FMV of the option privilege can be determined by the value of the property subject to the option, the probability of an increase or decrease in value, and the length of the option period.

The burden is on the taxpayer to prove that an option has a readily ascertainable value. Most NQSOs do not have a readily ascertainable value, and are therefore not taxed at the grant date.

 

Other Notes About the Exercise of Nonqualified Stock Options (NQSOs)

It is not unusual for an employer that has issued NQSOs to be acquired or merged into another entity. Rev. Rul. 2003-98 provides guidance on the tax consequences of the exercise or disposition of NQSOs after certain corporate transactions.

 

Transferring Nonqualified Stock Options (NQSOs)

The option may pertain to stock that is nontransferable or subject to a substantial risk of forfeiture (i.e., restricted stock). Here, compensation income generally is not recognized until the restrictions lapse, and it is based on the difference between the FMV of the stock when the restrictions lapse less the exercise price. This can be detrimental to the employee if the stock appreciates after the option is exercised and before the restrictions are lifted. Accordingly, if the stock is expected to appreciate, the employee might want to elect under IRC Sec. 83(b) to recognize the income when the option is exercised rather than when the restrictions lapse based on the appreciated value.