Here’s how to determine your basis and holding period for stock acquired by exercising nonqualified options.
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A nonqualified option (sometimes called a nonstatutory option) is a stock option that’s granted as compensation for services and doesn’t qualify as an incentive stock option. This type of option can be granted to employees (anyone who receives wages reported on Form W-2) or non-employees (independent contractors, outside directors). When you exercise this option you’re using it to buy stock, and it’s important to know the basis and holding period of the stock so you can correctly report the sale of the stock, regardless of whether the sale occurred at the same time as the exercise or afterward — perhaps years later.
Warning: Brokers are generally required to report the basis of shares acquired after 2010, but the basis reported by a broker for stock acquired by exercising a nonqualified option is often wrong. You need to determine the correct basis as explained below.
This page covers only the most common situation, where the following are true:
- The shares are vested when you exercise the option. In other words, this isn’t an “early exercise” option that lets you buy shares before they’re vested (typically only for pre-IPO companies).
- You’re paying cash for the shares, or treated as paying cash because the exercise price was covered by a sale of some of the shares. In other words, you didn’t use previously owned shares to pay the exercise price (swapping those shares for a larger number of shares).
You aren’t required to pay tax at the time you receive a nonqualified option or when it becomes vested. All the action, from a tax point of view, happens when you exercise the option, paying cash (the exercise price) to buy the stock. Although you don’t receive any cash in this transaction (that happens when you sell the stock, which may be later), you’re treated as having income because you received stock with a value greater than the amount you paid. The difference between these two amounts — the value of the stock and the amount you paid — is income when you exercise the option.
This income is treated as compensation for services. In other words, it is ordinary income, not capital gain. Employees are usually required to provide not only the exercise price of the option but also enough additional cash to cover income tax withholding and employment tax associated with the income that has to be reported on the exercise of the option.
Determining your holding period is easy: it starts when you exercise the option. You don’t get to include the time you held the option. Determining your basis isn’t quite that simple.
Step 1: amount paid for the stock
Your basis for this stock is composed of two items. The first is the amount paid for the stock. Usually this is easy to determine, as it is equal to the exercise price of the option.
There is one potential point of confusion. As noted above, employees are usually required to pay withholding in addition to the exercise price when they exercise a nonqualified option. This additional payment is not included in the basis of your shares.
Step 2: adjustment for income reported
To get the correct basis for your shares, you have to increase the amount paid for the shares by the amount of income reported on the exercise of the option. If you fail to make this adjustment, you’ll pay double tax on this amount, first as compensation income, and then as gain on sale of the shares.
- If you’re an employee, this income will appear on Form W-2. It’s included in your total wages in box 1, and should be broken out separately in box 12 with code V.
- For non-employees the income should appear on Form 1099-MISC, combined with any other income you received that year from the same company. It won’t be broken out separately as on Form W-2, although the company should be able to tell you how much income was reported for the option exercise.
You may need more detail than you can get from these forms to determine the correct basis of your shares. For example, you might exercise on more than one day in the year when the value of the stock differed, ending up with multiple lots of shares, each with different basis. The company should be able to provide you with the details needed to find the basis of each lot of shares.
Tip: After making this adjustment, you should find that the basis of the stock is about the same as the price at which the stock was trading when you exercised the option. Also note that if the basis reported by the broker wasn’t equal to the amount you paid for the stock, it should be equal to the basis you arrive at when you make this adjustment.
Your basis for these shares is the amount you paid for them (the exercise price of the option) plus the amount of income reported on the exercise of the option.
Tip: If your broker reported the basis of these shares on Form 1099-B, the figure appearing there may reflect only the amount paid for the shares, without the adjustment for income reported. If so, whoever prepares your income tax return will have to enter this adjustment with an appropriate code.