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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?

Fortunately, NSOs (non-qualified stock option) are much more straightforward compared to ISOs (incentive stock option). Taxes are owed twice: when we exercise the options and then when we sell the shares.

Tax on exercise

When we exercise our options, we will pay income tax on the difference between the fair market value (FMV) at the time and our exercise price (unless we early exercise). 

Regular exercising of NSOs will come with a tax bill—only early exercising can avoid taxes. When we exercise our NSOs, it will look like we made income 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: $20

Shares of NSO exercised: 1000

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

As an NSO holder with limited funds, we may end up deciding to hold off on exercising until a liquidity event, allowing us to sell shares easily. 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 only need to pay tax on the difference between the FMV at the time of exercise and our Sales Price, depending on how long we hold the shares.  

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 break out a few definitions used in the example below. Let's say we were granted NSOs at a strike price of $30 per share. We forgo early exercise and decide to wait. When we finally decided to exercise our options a year later, the FMV was $50. We ended up selling our shares for $90 each.

  • Sale Price refers to the price at which we sell our common stock in the company
  • FMV on Exercise refers to the fair market value of shares when we exercised our options to buy common stock
  • Grant Date refers to the date that we receive our options and on that date the fair market value of the shares is the same as the strike price
Source: PwC

The $20 difference between the strike price and the FMV is recognized as 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 is even more important for this type of stock option. The $60 difference would be taxed at the long-term capital gains by early exercising, just as if they were qualified ISOs. Read more about early exercising here.

Depending on when we joined the company, a QSBS exemption may allow us to avoid paying taxes altogether. The QSBS exemption requires early exercising and a longer holding period. Read the lesson on early exercise first to understand what's needed for QSBS. 

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.

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