Fairmark.com
HomeOur BooksTax Help Center
Roth IRAsOptionsCapital GainsKids/CollegeMessage Board

 
Fairmark Press
Tax Help Center
Message board
About Us
Contact Us


Capital Gains, Minimal Taxes (click for info)


Consider Your Options 2007
 

Go Roth! (click for info)

Capital Gains > Determining Basis > Stock from Options

Stock from Nonqualified Options

Rules for determining your basis and holding period for stock from nonqualified stock options.

This page explains how to determine your initial basis in stock acquire when you exercise a nonqualified option. The discussion makes the following assumptions:

  • You received an option in connection with the performance of services (as an employee, director, consultant, etc.).
  • The option is not an incentive stock option.
  • The option is not freely tradable on an established securities market.
  • You acquired stock by exercising the option and paying cash. (Different rules, not covered here, apply if you paid for the stock by surrendering shares of stock you previously owned.)

Note: This page is part of our general guide to buying and selling stock and deals only with the basis of your shares. A guide to tax issues involving nonqualified options and incentive stock options appears in our Guide to Compensation in Stock and Options.

Background

You aren't required to pay tax at the time you receive a nonqualified option. All the action, from a tax point of view, happens when you exercise the option.
    At that time, you pay a certain amount of cash (the exercise price) to buy the stock. Although you are paying money and not receiving money, the tax law treats you as if you received income. The amount of income is the difference between (a) the fair market value of the stock you bought, and (b) the amount you paid for it. The idea is that you received a benefit by purchasing the stock for an amount less than its value, so that benefit should be treated as income.
    This income is treated as compensation for services. In other words, it is ordinary income, not capital gain. If you are an employee, your employer is required to report this amount as wages. Your employer is also required to withhold against this income. But the income isn't in the form of cash, and the employer can't meet the withholding requirement by sending stock to the IRS. So you may be required to pay more money (in addition to the purchase price of the stock) to satisfy the withholding requirement.

Determining Your Initial Basis

Your initial basis for the stock is equal to (a) the amount you paid for the stock, plus (b) the amount you were required to report as income. In other words, your initial basis for the stock is equal to its fair market value at the time you exercised the option.
    Your initial basis for the stock does not include any amount you may have paid to satisfy the withholding requirement. This money is a credit on your taxes for the year you exercised the option, but does not add to your basis.
    Your holding period for the stock (used to determine whether you have a long-term gain when you sell the stock) begins on the day you exercise the option. You are not allowed to include the period of time when you held the option.

Example: In 1999, you received an option to acquire 200 shares of XYZ (your employer) at $25 per share. You were not required to report any income at that time. In 2001, when the stock was trading at $40, you exercised the option. You paid $5,000 to buy 200 shares worth $8,000. This means you had income of $3,000. To satisfy the withholding requirement (federal and state), you had to pay an additional $930. Your basis for the stock is $8,000. Your income for 2001 includes $3,000 from exercising the option, and your withholding credits include the additional $930 you paid.

Note: Technically, your basis for the stock includes three things. In addition to the two mentioned above (the amount paid for the stock and the amount of income you had), it includes any amount you paid to receive the nonqualified option. It is unusual to pay anything for a nonqualified option, so in most cases your basis will include only the two items mentioned.

1  2  3  4  5  6  a  b  c  7   

   

A publication of Fairmark Press Inc.
Copyright 1997-2008, Kaye A. Thomas  All rights reserved

 
 

About Us    Contact Us    Legal    Home