Nonqualified Stock Options Before Exercise

Generally you have nothing to report in connection with a nonqualified option prior to exercise. There are a few points you should be aware of nonetheless.

Receiving a nonqualified option

With rare exceptions, there’s no tax to pay, and nothing to report, at the time you receive a nonqualified option. The exceptions:

• You receive an option that’s actively traded on an established securities market.
• You receive an option that meets the stringent tests required for an option to have a “readily ascertainable value” as defined in the regulations.
• The option is “in the money” at the time it is granted.

All these exceptions are extremely rare. The first two exist in the law but are never seen in practice. The third comes up only in connection with very unusual compensation arrangements, and should be avoided due to potential adverse tax consequences under section 409A of the Internal Revenue Code.

In all other cases you have nothing to report at the time you receive an option. This is true even if the option is fully vested when you receive it. You should, however, take care to do the following:

• Read the option agreement carefully, making certain you understand your rights — and any circumstances in which you could lose those rights.
• Obtain copies of any other relevant documents, such as the stock option plan under which the option was issued and any summary of the plan or agreement. Review these items, then file them with the option agreement in a safe place.
• Start planning now for the eventual exercise of your option. When do you expect to exercise? Will you need to come up with a large sum of cash? If so, how will you do so? What tax considerations will apply?

No section 83b election

There’s persistent confusion among taxpayers — and some tax advisors — about a tax technique called the section 83b election. This election can provide tax savings when you receive stock that’s not vested. But the election doesn’t apply when you receive an option except in the unusual situation where the option itself is taxable as described above. If someone tells you there’s an election you can make to reduce your tax when you receive an option, forget it.

No tax when option vests

You may receive an option that isn’t immediately exercisable. You’re permitted to exercise the option only if you continue to work for the same company for a stated period.

Example: You receive an option to buy 300 shares of your employer’s stock, but you’re not permitted to exercise the option immediately. If you’re still employed with that company a year later you become eligible to exercise half of this option. After another year of employment the option is fully exercisable.

The dates on which the option becomes exercisable are called the vesting dates. These dates are obviously significant, but you don’t report income on these dates.

Note: The rule is different when you receive grants of stock from your employer. As a general rule, you do report income when a stock grant vests. But there’s nothing to report on your income tax return when an option grant vests.