Initial Tax Consequences

• Employees and other recipients of NQSOs need not worry about any tax consequences when they receive these option grants. The accounting piece enters the picture only upon their exercise, at which time the option holders must report compensatory income that amounts to the difference between the exercise price and its actual value. For example, if an employee granted the right to purchase 100 company shares at $50 per share exercises that option when the stock's fair market value is $60, the individual must report $1,000 (the $10 difference multiplied by 100 shares) as regular income for that year.
  
  

W-2 Form

• Upon the initial NQSO grant, neither employers nor employees must report any income. This occurs only upon the option's exercise, at which time employers must report this amount as compensation on a W-2 form. Accordingly, all taxes must then be withheld as usual, including for federal and state income taxes, Social Security, Medicare, unemployment compensation and state taxes.
  
  

Tax Basis

• The tax basis represents the total amount paid to acquire the stock, after which capital gains or losses are calculated based on the price at the time of sale. For NQSOs, the tax basis is the fair market value upon exercise of the option, which includes the price paid plus the extra amount reported as compensation on the W-2. This is an essential figure, and must be reported in one amount on Schedule D within the option holder's Form 1040.
  
  

Time Frames

• The time frame for which an option is exercised and subsequently sold can make a substantial difference in the amount of taxes due. If holders retain them for at least one year before cashing in, they can treat the subsequent profit as a long-term capital gain, which is subject to a maximum tax rate of 20 percent. It is otherwise treated as a short-term capital gain and taxed the same as regular income, which is typically at a higher rate.