Exercising Nonqualified Stock Options.
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.

How can I minimize taxes by donating non-qualified stock options?
I have vested non-qualified stock options with a private equity owned company which is looking at an IPO. I want to donate them to a public donor advised fund, but would also like to minimize the tax I must pay, if any. Should I donate them prior to exercising, after exercising but before selling, or after both exercising and selling? What are the tax consequences of each? I am looking to do this soon because there might be a recap prior to the actual IPO.
Barringer, John.
Non-qualified employee stock options (NQSOs) are not generally good candidates for charitable giving. The income tax consequences with respect to NQSOs are governed by Internal Revenue Code (IRC) Section 83. There is no prohibition on lifetime transfers under the IRC, but the terms of your company stock option plan govern the transfers of stock options. The terms should be reviewed prior to a transfer. The terms of many plans allow transfers only to family members or to legal entities established for the benefit of family members, thus preventing transfers of the stock options to charity, outright. Sometimes, the terms of the plan allow charitable transfers, but only with the consent of the board of directors or a committee of the board.
Assuming the plan allows transfers to non-family members, they may be better testamentary bequests than living ones. This is because the IRS has ruled that ". a contribution of an NQSO to charity does not trigger the immediate recognition of income to the employee, although the employee continues to be subject to Section 83 when the option is ultimately exercised by the charity." This means that when the charity exercises the option, the employee becomes responsible for the ordinary tax on any gain above fair market value of the stock at the time of exercise.
Furthermore, the IRS has ruled that. "if NQSOs-which have been held for over a year-are then contributed to charity, the available charitable income tax deduction (appears) to be limited to the tax basis of the options," given that the Section 170(e)(1)(A) reduction rules should be applicable and because the option was likely not taxed at grant, the employee has a zero tax basis, so no charitable deduction is available.
If the company has not yet gone public and the valuation of the stock is low compared to what you expect it to be after the IPO, you should consider early exercising the shares (if the plan allows it) and holding them until after the IPO, at which time you could receive the benefit of a charitable deduction for the market value at the time of the bequest. This would allow you to perhaps make a large gift but it isn't likely that you can do more than employ a strategy designed to minimize the ordinary income tax consequences of the exercise itself.

How to minimize taxes on non qualified stock options

Subject: Taxes on non-qualified employee stock options.
Date: Tue, 9 Mar 1999.
Myself and others within my company are looking for ways to minimize the tax impact on the nonqualified employee stock options which we have received from our company.
We work for Sterling Wentworth Corporation which was recently aquired by Sungard Data Systems.
Is there anything that can be done to reduce the tax burden?
I found some information at: taxhavenroadmap/ca_stock_option. html which seems to indicate that the liability can be eliminated with the use of an offshore entity, but I can’t get any information on this strategy. Do you know if this is possible?
Thank you for your assistance.
Date: Sun, 21 Mar 1999.
Don’t let the “tax tail” wag the dog.
There are issues of timing, elections when the stock received is restricted or not vested, etc., but if you receive the benefits of receiving the stock at a bargain price, there is going to be a taxable event.
I would not endorse using offshore trusts to avoid the tax. You have to give up control of the assets and not have access to them in the U. S. to have a hope of avoiding tax. Do you really want to do that?
Be grateful for the gift that you have, and plan how and when you will benefit from it.

Get The Most Out Of Employee Stock Options.
An employee stock option plan can be a lucrative investment instrument if properly managed. For this reason, these plans have long served as a successful tool to attract top executives. In recent years, they've become a popular means to lure non-executive employees.
Unfortunately, some still fail to take full advantage of the money generated by their employee stock. Understanding the nature of stock options, taxation and the impact on personal income is key to maximizing such a potentially lucrative perk.
What's an Employee Stock Option?
An employee stock option is a contract issued by an employer to an employee to buy a set amount of shares of company stock at a fixed price for a limited period of time. There are two broad classifications of stock options issued: non-qualified stock options (NSO) and incentive stock options (ISO).
Non-qualified stock options differ from incentive stock options in two ways . First, NSOs are offered to non-executive employees and outside directors or consultants. By contrast, ISOs are strictly reserved for employees (more specifically, executives) of the company. Secondly, nonqualified options do not receive special federal tax treatment, while incentive stock options are given favorable tax treatment because they meet specific statutory rules described by the Internal Revenue Code (more on this favorable tax treatment is provided below).
NSO and ISO plans share a common trait: they can feel complex. Transactions within these plans must follow specific terms set forth by the employer agreement and the Internal Revenue Code.
Grant Date, Expiration, Vesting and Exercise.
To begin, employees are typically not granted full ownership of the options on the initiation date of the contract, also know as the grant date. They must comply with a specific schedule known as the vesting schedule when exercising their options. The vesting schedule begins on the day the options are granted and lists the dates that an employee is able to exercise a specific number of shares.
For example, an employer may grant 1,000 shares on the grant date, but a year from that date, 200 shares will vest, which means the employee is given the right to exercise 200 of the 1,000 shares initially granted. The year after, another 200 shares are vested, and so on. The vesting schedule is followed by an expiration date. On this date, the employer no longer reserves the right for its employee to purchase company stock under the terms of the agreement.
An employee stock option is granted at a specific price, known as the exercise price. It is the price per share that an employee must pay to exercise his or her options. The exercise price is important because it is used to determine the gain, also called the bargain element, and the tax payable on the contract. The bargain element is calculated by subtracting the exercise price from the market price of the company stock on the date the option is exercised.
Taxing Employee Stock Options.
The Internal Revenue Code also has a set of rules that an owner must obey to avoid paying hefty taxes on his or her contracts. The taxation of stock option contracts depends on the type of option owned.
For non-qualified stock options (NSO):
The grant is not a taxable event. Taxation begins at the time of exercise. The bargain element of a non-qualified stock option is considered "compensation" and is taxed at ordinary income tax rates. For example, if an employee is granted 100 shares of Stock A at an exercise price of $25, the market value of the stock at the time of exercise is $50. The bargain element on the contract is ($50 to $25) x 100 = $2,500. Note that we are assuming that these shares are 100 percent vested. The sale of the security triggers another taxable event. If the employee decides to sell the shares immediately (or less than a year from exercise), the transaction will be reported as a short-term capital gain (or loss) and will be subject to tax at ordinary income tax rates. If the employee decides to sell the shares a year after the exercise, the sale will be reported as a long-term capital gain (or loss) and the tax will be reduced.
Incentive stock options (ISO) receive special tax treatment:
The grant is not a taxable transaction. No taxable events are reported at exercise. However, the bargain element of an incentive stock option may trigger alternative minimum tax (AMT). The first taxable event occurs at the sale. If the shares are sold immediately after they are exercised, the bargain element is treated as ordinary income. The gain on the contract will be treated as a long-term capital gain if the following rule is honored: the stocks have to be held for 12 months after exercise and should not be sold until two years after the grant date. For example, suppose that Stock A is granted on January 1, 2007 (100% vested). The executive exercises the options on June 1, 2008. Should he or she wish to report the gain on the contract as a long-term capital gain, the stock cannot be sold before June 1, 2009.
Other Considerations.
Although the timing of a stock option strategy is important, there are other considerations to be made. Another key aspect of stock option planning is the effect that these instruments will have on overall asset allocation. For any investment plan to be successful, the assets have to be properly diversified.
An employee should be wary of concentrated positions on any company's stock. Most financial advisors suggest that company stock should represent 20 percent (at most) of the overall investment plan. While you may feel comfortable investing a larger percentage of your portfolio in your own company, it's simply safer to diversify. Consult a financial and/or tax specialist to determine the best execution plan for your portfolio.
Bottom Line.
Conceptually, options are an attractive payment method. What better way to encourage employees to participate in the growth of a company than by offering them to share in the profits? In practice, however, redemption and taxation of these instruments can be quite complicated. Most employees do not understand the tax effects of owning and exercising their options.
As a result, they can be heavily penalized by Uncle Sam and often miss out on some of the money generated by these contracts. Remember that selling your employee stock immediately after exercise will induce the higher short-term capital gains tax. Waiting until the sale qualifies for the lesser long-term capital gains tax can save you hundreds, or even thousands.