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NSO exercise and sales tax

Lesson in Course: Finance at work (advanced, 7min)

We want to exercise and sell our non-qualified stock options. What should we expect for taxes?

Eureka!

What it's about: The tax rules for selling NSOs.

Why it's important: Even if we aren't granted ISOs, the $100k rule can result in our ISOs splitting into NSOs.

Key takeaway: If possible, hold our NSOs for at least one year after exercising before selling.

There will come a day where we have the chance to sell our NSOs. Whether that day is coming soon or is still far away, we will need to formulate a plan on what to expect for taxes. Fortunately, NSOs are fairly straightforward. Taxes are owed when we exercise the options and then when we sell the shares.

Waiting to exercise when we sell

While we already covered exercise tax when we learned about the difference between NSOs and ISOs, we're going to quickly revisit it again for NSOs in the case we decide to wait to exercise until we sell our shares.

Exercising NSOs is always taxable

When we exercise our options, we will owe income tax on the difference between the FMV at the time and our strike price (unless we early exercise). When we exercise our NSOs, income is reported to the IRS regardless of whether we can sell the shares for cash or not. Our exercise will show up on our W-2.

W-2 Example

Strike price: $30, FMV: $50

Difference: $(50-$30)=$20

Shares of NSO exercised: 1000

Amount of income reported on our W2: $20 x 1000 = $20,000

Employees who have received NSOs and can't afford to pay the income tax can decide to hold off on exercising until a liquidity event. While it's not as favorable from a tax standpoint, selling the shares at the same time as exercising can provide us the cash we need to pay the exercise tax.

 

Sales tax

Upon selling our shares, we will need to pay capital gains tax on any difference between the FMV at the time of exercise and our sales price.

Capital gains tax owed

If we wait for a year after exercising to sell, the gains would be long-term capital gains, and if not, they would be short-term capital gains. Let’s walk through an example below.

Example of NSO tax on sale

Let's say we were granted NSOs at a strike price of $30 per share. We forgo early exercise and decide to wait to exercise our options a year later. The FMV at the time of exercise was $50 and we ended up selling our shares a little while after for $90 each.

Source: PwC

The $20 difference between the strike price and the FMV is recognized as ordinary income when we exercise. 

The difference of $40 ($90 - $50) between the sale price and the FMV can either be long-term capital gains or short-term capital gains.

Since NSOs have no preferred tax treatment, early exercising can effectively turn NSOs back into ISOs. Had we early exercised, the entire $60 difference would be taxed at the long-term capital gains.

 

Exercising and selling at the same time

In the case we have not exercised and cannot afford to pay the taxes to exercise or wait a year to sell, we'll need to bite the bullet and pay income tax on the whole amount. The FMV at the time of exercise is the same as our sales price, and so the difference between the strike price and the sales price is taxed as income.

Exercise and sell taxes

In the graph above, we can see that we'd owe taxes on $60 worth of income for every share sold.

Actionable ideas

If we are granted NSOs or end up receiving NSOs through an ISO/NSO split, we should consider early exercising if we are able to and can afford the risk.

If we can't early exercise or don't have that option, timing our stock sales may save quite a lot in taxes. For example, at the first liquidity event, selling a small portion initially will bring in some cash while we let the rest of the shares appreciate and qualify for long-term capital gains to save on taxes. Check-in with a tax advisor if you have questions or reach out to the Archimedes team.