The good news is that the tax rules surrounding nonqualified stock options, or NQSOs, are simple. The bad news is that the IRS treats NQSOs less favorably than Incentive Stock Options — but there isn't much you can do about that.
Sales of NQSOs
When you exercise a NQSO, the spread between your exercise price and the market price — your profit — is generally taxed at ordinary income rates in that year's tax return. (In unusual cases, where the options are traded in a securities market, the tax may accrue on the grant date.)
After you exercise the option, of course, you own the stock and your new tax basis is the market price on the exercise date. You now have a choice. If you hold the stock for more than a year after the exercise date, it appreciates, and if you sell, your gain is taxed as a capital gain. If it appreciates and you sell it before more than 12 months are up, it is taxed as regular income. In either case, if you sell for less than the market price on the exercise date, you have a loss that can offset other gains.
Confused? An example should help. Say on June 30, 2010, you receive a NQSO giving you the right to purchase 100 shares of employer stock for $10 a share. You then exercise on June 2, 2011, when the market price is $16, giving you a $600 profit ($6 x 100 shares). In this case, you would have paid 2011 tax on the $600 spread at your ordinary rate (which could run as high as 35%). Your per-share basis becomes $16 (the market value on the exercise date) and your holding period for calculating taxes on future sales starts on June 3, 2011. Then let's say you sell on Aug. 2, 2012, for $25 a share, giving you a $900 long-term capital gain. The gain qualifies for the 15% maximum federal rate because you held the shares over 12 months.
The calculator below will do the math for you. If you haven't exercised yet, we'll tell you what your tax liability would be if you did so today. And if you already own stock from exercising an option, we'll tell you what you'd owe today if you sold. One thing — the calculator will ask you for your "estimated marginal tax rate." To calculate that, click here.