NSOs and Taxation Part 2

So, you tuned in for the deep dive into NSO taxation. You’re either a nerd like me who really loves taxes or need to know what to do in your situation! I want to give you some real-world examples of how the taxation of NSOs work. So, for those of you who would like to take a deep dive into the numbers, keep reading. 

Holding indefinitely

If you hold your exercised option purchase indefinitely, the only tax you will ever pay is on the earned income. Remember our equation: (Market $ – Exercise $) x Share # = Compensation? You’ll have federal income taxes withheld at 22%, your state income tax rate if applicable, and your share of Social Security and Medicare taxes. Remember, you must come up with the money to pay those taxes. That could be a big chunk of change. 

• Exercise Date: 7/1/23

• Number of shares: 250

• Market Price: $11

• Exercise Price: $1

• Compensation: ($11 – $1) x 250 = $2500

• Federal Tax (22%): $550 

• Social Security & Medicare (7.65%): $191.25

• Total Tax: $741.25

• Net Gain (unrealized): $1,758.75

Taxes take a big bite, and you don’t receive any more cash in your bank account (unrealized) but have a big tax bill.

Same day sale

If you take the scenario above, but the same day you exercise your grant, you sell all 250 shares; you’ll have all the taxes to pay as shown above, but you will realize cash in your investment account. When you exercise your option to buy the stock at a market price of $11, that becomes your new cost basis on which all gains and losses from the sale now or in the future will be based. You may pay a commission or transaction fee to sell your 250 shares, reducing your net gain. Oh, and there’s also this “special” tax called the Net Investment Income Tax (NIIT), a surcharge on investment gains based on your income that could add 3.8% to your bill. NITT is important to discuss in this context because large gains are squarely in the crosshairs of the NIIT tax if your company stock appreciates substantially after you have exercised your NSO.

• Exercise Date: 7/1/23

• Number of shares: 250

• Market Price: $11/share

• Exercise Price: $1/share

• Compensation: ($11 – $1) x 250 = $2,500

• Federal Tax (22%): $550 

• Social Security & Medicare (7.65%): $191.25

• Total Tax: $741.25

• Sale Date: 7/1/23

• Sale Price: $11/share

• Cost Basis: $11/share

• Transaction Fee: $10

• Capital Loss: ($11 – $11) x 250 – $10 = -$10

• Net Gain (realized): $1,748.75

The good thing is that you have money in your investment account to compensate for the taxes taken from your paycheck. You also have a capital loss to report when you file your tax return.

Short-term sale with a gain

This time you decide to hold your 250 shares for a few months and then sell them. That day, however, the share price is up from your new cost basis of $11/share. You already had all the taxes withheld on the compensation, so at least that’s out of the way. This additional gain qualifies as a short-term capital gain because you held the stock for less than one year, so you pay additional ordinary income taxes. 

• Exercise Date: 7/1/23

• Number of shares: 250

• Market Price: $11/share

• Exercise Price: $1/share

• Compensation: ($11 – $1) x 250 = $2500

• Federal Tax (22%): $550 

• Social Security & Medicare (7.65%): $191.25

• Total Tax: $741.25

• Sale Date: 9/1/23

• Sale Price: $16/share

• Cost Basis: $11/share

• Transaction Fee: $10

• Capital Gain: ($16 – $11) x 250 – $10 = $1,240

• Short-term gain taxes (22%): $272.80

• NIIT (3.8%) if applicable: $47.12

• Net Gain (realized): $2,678.83

Long-term sale

In our final scenario, the only change you make here is that you hold your shares until the day after the first anniversary of buying your stock before selling them. Today, the share price is still $16, which gives you the same gain, but because you held the shares for over a year, your income puts you at the 15% capital gains rate.

• Exercise Date: 7/1/23

• Number of shares: 250

• Market Price: $11/share

• Exercise Price: $1/share

• Compensation: ($11 – $1) x 250 = $2500

• Federal Tax (22%): $550 

• Social Security & Medicare (7.65%): $191.25

• Total Tax: $741.25

• Sale Date: 9/2/24

• Sale Price: $16/share

• Cost Basis: $11/share

• Transaction Fee: $10

• Capital Gain: ($16 – $11) x 250 – $10 = $1,240

• Long-term gain taxes (15%): $186

• NIIT (3.8%) if applicable: $47.12

• Net Gain (realized): $2,765.63

And there you have it. Four varying ways the tax man comes for that sweet benefit you exercised. This illustrates only a few of the possibilities. We can help you to understand your specific NSO situation and give you confidence before you decide what to do. We are adept at examining your company’s financials and always recommend what is in your best interests. Schedule a call with us today!

Want to know more about other alternate forms of employer compensation? Check out the links below.

Incentive Stock Options (ISO)

Restricted Stock Units (RSU)

Employee Stock Purchase Programs (ESPP)

Non-Qualified Deferred Compensation (NQDC)