What you need to know when you exercise nonqualified 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. But in general you’ll report compensation income equal to the bargain element at the time of exercise.

Note: The rules described here apply if the stock is vested when you receive it. Generally, stock is vested if you have an unrestricted right to sell it, or you can quit your job without giving up any of the value of the stock. See When Stock Is Vested. 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 .

Bargain element

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.

Example: You have an option that gives you the right to buy 1,000 shares of stock for $15 per share. If you exercise the entire option at a time when the value of the stock is $40 per share, the bargain element is $25,000 ($40,000 minus $15,000).

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.

Bargain element as income

The bargain element in the exercise of an option received for services is considered compensation income. In the example above, you would report $25,000 of income, just as if the company had paid you a cash bonus of $25,000. You’re not allowed to treat this amount as capital gain.

The amount of tax you’ll pay depends on your tax bracket. If the entire amount falls in the 30% bracket, for example, you’ll pay $7,500 (plus any state or local income tax). 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.

Withholding

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.

Example: You exercise an option to purchase 1,000 shares for $15 per share when they’re worth $40 per share. The company requires you to pay $15,000 (the exercise price for the stock) plus $9,000 to cover state and federal withholding requirements.

The amount paid must cover federal and state income tax withholding, and the employee share of employment taxes as well. The amount paid as income tax withholding will be a credit against the tax you owe when you report the income at the end of the year. Be prepared: the amount of withholding required won’t necessarily be large enough to cover the full amount of tax. You may end up owing tax on April 15 even if you paid withholding at the time you exercised the option, because the withholding amount is merely an estimate of the actual tax liability.

Non-employees

If you aren’t an employee of the company that granted the option (and weren’t an employee when you received the option), withholding won’t apply when you exercise it. The income should be reported to you on Form 1099-MISC instead of Form W-2. Remember that this is compensation for services. In general this income will be subject to the self-employment tax as well as federal and state income tax.

Basis and holding period

It’s important to keep track of your basis in stock because this determines how much gain or loss you report when you sell the stock. When you exercise a nonqualified option your basis is equal to the amount you paid for the stock plus the amount of income you report for exercising the option. In the example we’ve been using, your basis would be $40 per share. If you sell the stock at some later date for $45 per share, your gain will be only $5 per share, even though you paid just $15 per share for the stock. The gain will be capital gain, not compensation income.

For certain limited purposes (particularly under the securities laws) you’re treated as if you owned the stock during the period you held the option. But this rule doesn’t apply when you’re determining what category of gain or loss you have when you sell the stock. You have to start from the date you bought the stock by exercising the option, and hold for more than one year to get long-term capital gain.

Other methods of exercise

The description above assumes you exercised your nonqualified option by paying cash. There are two other methods of exercising options that are sometimes used. One is the so-called cashless exercise of an option. The other involves the use of stock you already own to pay the exercise price under the option. These methods, and their tax consequences, are described in the pages that follow.