Nonqualified Stock Options: Tax Withholding on Former Employees

Share the risks associated with a growing business. Employee's Withholding Allowance Certificate. Thanks for using UpCounsel! It may be possible to use the stock you're receiving as security for the loan. Employees can do the following:. Employer's Quarterly Federal Tax Return. To give your employees favorable tax treatment with qualified stock options.

Your nonqualified stock option gives you the right to buy stock at a specified price. You exercise that right when you notify your employer of your purchase in accordance with the terms of the option agreement. The precise tax consequences of exercising a nonqualified stock option depend on the manner of exercising the option.

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If the stock isn't vested when you exercise the option, apply the rules for restricted stock described in Buying Employer Stock and Section 83b Election. The bargain element in the exercise of an option is the difference between the value of the stock on the exercise date and the amount paid for the stock.

The value of the stock should be determined as of the date of exercise. For publicly traded stock the value is usually determined as the average between the high and low reported sales for that date.

For privately held companies the value must be determined by other means, perhaps by reference to recent private transactions in the company's stock or an overall appraisal of the company. Fair Market Value of Stock Bargain element as income The bargain element in the exercise of an option received for services is considered compensation income.

You're not allowed to treat this amount as capital gain. The amount of tax you'll pay depends on your tax bracket. If you exercise a large option, it's likely that some of the income will push up into a higher tax bracket than your usual one. The important thing to focus on — ahead of time if possible — is that you have to report this income, and pay the tax, even if you don't sell the stock. You haven't received any cash; in fact, you paid cash to exercise the option, but you still have to come up with additional cash to pay the IRS.

This is one reason advance planning is important in dealing with options. If you're an employee or were an employee when you received the option , the company is required to withhold when you exercise your option. Of course the withholding obligation must be satisfied in cash. The IRS won't accept shares of stock! There are various ways the company can handle the withholding requirement. The most common one is simply to require you to pay the withholding amount in cash at the time you exercise the option.

The amount paid must cover federal and state income tax withholding, and the employee share of employment taxes as well.

The amount is treated like compensation income, and you will owe income tax, social security tax , and medicare taxes. A company is required to withhold a certain amount of cash to cover federal and state income tax withholding and the employee's share of employment taxes as well. The amount paid as income tax withholding will be a credit against the tax the employee owes when reporting income at the end of the year, but the withholding may not cover the full amount of tax since it is an estimate of the actual tax liability.

There are two key differences — who the stock can be issued to and the tax treatment. Qualified stock options, also known as incentive stock options , can only be granted to employees. Non-qualified stock options can be granted to employees, directors, contractors and others.

This gives you greater flexibility to recognize the contributions of non-employees. Qualified stock options may also qualify for special tax treatment.

If eligibility and holding period requirements are met, the bargain element is taxed as a capital gain to the employee. For non-qualified stock options, the bargain element is treated as ordinary income to the employee.

Issue stock options to individuals who aren't eligible for qualified stock options. You may want to consider avoiding non-qualified stock options in the following situations. As a total substitute for cash compensation. Inadequate cash salaries may hinder your recruiting. To preserve equity for future financing, to bring in other key employees, or to leave yourself with an adequate share of the company. Employees can do the following:. Exercise and immediately sell. Exercise, hold for longer than one year, then sell.

Exercise, hold for less than one year, then sell. Assume the same facts as above except the stock is held for less than one year. They pay no money, receive nothing and have no tax consequences. Employees can exercise their option even if the value has fallen below the exercise price.

This may happen if they are near the expiration date but believe the value will increase in the long-term. They must still pay the full exercise price to exercise the option, but will not be taxed on exercise because the bargain element is negative. If you set the exercise price below the fair market value on the grant date, employees must immediately pay tax on this amount. The amount of the bargain element that the employee reports as ordinary income is generally deductible as a compensation expense.

Withholding is required only for employees and, in some cases, former employees. Note that if you aren't an employee you'll generally have to pay self-employment tax on any amount that's treated as compensation for services.

In general, withholding is required in situations where an employee is required to report compensation income:. There's an exception to this general rule. If you make a disqualifying disposition of stock acquired by exercising an incentive stock option, or you have to report compensation income from disposition of stock you acquired under an employee stock purchase plan, the IRS does not require withholding. The special problem in withholding on compensation paid in stock is that you aren't receiving any cash.

Naturally the IRS insists that the withholding be provided in cash. How can you provide cash withholding when you didn't receive any cash? Some companies help with this problem by providing some form of cash compensation that goes along with the stock compensation. This may take the form of a stock appreciation right or cash bonus plan. Note, however, if the company covers your withholding, the amount they pay for that purpose is additional income to you.

Among tax pros, this is called grossing up the payment. Most companies expect you to cover the withholding.

Frequently Asked Questions

If the option was granted in the context of employment, then you have to withhold income and employment tax withholding, even if the optionee is no longer an employee at the time of exercise. The character of the payment is wages. Do you know the tax implications of your non-qualified stock options? For general information, request Michael Gray’s special report, “Non-Qualified Stock Options – Executive Tax and Financial Planning Strategies”.For answers to specific questions, bookmark this page and read the list below for questions Michael Gray has already answered. Non-qualified stock options can be granted to employees, directors, contractors and others. This gives you greater flexibility to recognize the contributions of non-employees. Qualified stock options may also qualify for special tax treatment.