NSO Taxation
NSO taxation can be complex. Here is what you need to know!
Pre-Read: Key Questions This Article Answers
What are the tax implications of non-qualified stock options (NSOs)?
Will exercising NSOs generate AMT [answer: no, they won't]
Why do I need to be VERY careful the tax basis of the shares I buy with NSOs?
When are taxes due with NSOs (at grant? when they vest? when exercised? when sold?)
Tax Implications of NSOs
NSO taxation is modestly straightforward. There are a handful of nuances to understand, but the when/how is it taxed, and strategies related to that are comfortably understandable for most.
When taxation occurs: NSOs are taxed when they are exercised (no taxation occurs when it is granted; except in very unique situations where the NSO grant strike price is not the same as the FMV).
Taxation type (ordinary income): When an NSO is exercised, the bargain element (if any) is considered ordinary income. So if you exercise 5,000 NSOs with a $2 per share bargain element, you'll generate $10,00 of income. As ordinary income, it is also subject to FICA taxes (Medicare; Social Security) and state taxes (if applicable). Once exercised, the FMV the day you exercised becomes your per-share tax basis, which will be used to determine capital gain/losses (and associated capital gains tax) down the line when you sell.
Withholding: Taxes are withheld on NSOs when they are exercised (assuming there is a bargain element; if there is none then no income was generated and nothing needs to be withheld). Withholding for FICA and state taxes (if applicable) will also apply.
Unique Items and Special Situations
Exercised NSOs Can Have an "Incorrect" Cost Basis (You'll Need to Adjust Your Taxes)
Brokerage firms are required to list your cost basis for NSO-exercised shares as the strike price. It's frustrating, because for tax purposes (which is primarily what you care about), your tax cost basis per share is the FMV when you exercised the NSOs, not the strike price. This also means that when you sell the shares the tax docs and associated gains/losses on your 1099 in the year you sell NSO-exercised shares will be wrong. For more details see: Correcting the Cost Basis of NSO-Exercised Shares Post-IPO
Early Exercising NSOs Can Eliminate Any Taxes Upon Exercise
If your NSO grant allows early exercising, opting to do so when it's granted (or soon thereafter) will likely result in no taxes being due upon exercise. When an NSO is granted, the strike price is almost always the FMV/409A price. If you exercise soon thereafter, the FMV is unlikely to have changed, and thus the bargain element (FMV - strike price) should be $0. For more details see: Exercise NSOs Earlier; and/or 83b Election
This strategy can have high risk. Early exercising will likely allow you to avoid paying income taxes upon exercise, but you still need to pay to purchase the shares. If the company is unsuccessful (most are), you lose your invested funds.
Understanding 409a Valuation Rules/Frequency May Help You Reduce Your Tax Bill
The income tax (if any) you will owe when exercising NSOs at a pre-IPO company is a function of the 409a valuation. As noted here (409a Valuation), certain events and situations can trigger a 409a valuation to be updated, and understanding your company’s business dynamics can help you strategize on timing. For example, if a new VC round seems likely in the next 3-6 months, and is anticipated to be at a higher valuation, the 409a will likely increase soon. If you desire to exercise your NSO, exercising prior to the anticipated 409a update will likely result in a lower tax bill.
Exercising NSOs Early in Your Company’s Life to Meet a Key QSBS Qualification Item
Qualified Small Business Stock (QSBS) provides very attractive tax benefits, potentially allowing up to $10 million of gains per taxpayer ID to be tax-free. However, there are many requirements to qualify for QSBS treatment. One of the most significant is that the stock must be purchased prior to the company ever having more than $50 million in assets. If your company is anticipated to conduct a VC raise that would result in its assets (including cash raised) exceeding $50m, exercising prior to then would allow you to meet this requirement. As with all exercise/purchase strategies however, this comes with significant investment risk.
Exercising Underwater NSOs Has No Tax Impact
If the strike price of your NSOs is more than your current FMV, your NSOs are known as being "underwater". Exercising underwater options does not result in taxable income (the realized value at exercise is actually a loss, but you don't get any benefit for that for tax purposes).
In most cases exercising underwater NSOs should be avoided; but in rare cases it can make sense. Due to the multiple different ways a company is valued, a NSO could be "underwater" based on the current 409a valuation, but an anticipated acquisition could be at a materially larger value
There is No Tax Benefit for "Exercising and Holding" NSOs at a Public Company
A common misconception we frequently hear from clients is "I want/plan to hold my NSOs for at least a year after exercising them to get the tax benefits". For all intents and purposes, this is false.
Why the misconception? Some individuals have been told/believe that if they hold shares for 1-year (or more) after exercising NSOs, they will get (lower) long-term-capital-gains treatment instead of (higher) ordinary income tax. This is potentially minorly true (i.e. the misconception), but only on the change in stock price after the NSO exercise would get capital gains tax treatment (which is identical to how any other stock invested is treated). For example, let's say:
Tiffany exercises 1,000 NSOs with a $1 strike price, when the stock is trading at $51 a share. This results in:
$50,000 of income is generated/triggered upon exercise
To exercise the NSO, Tiffany is required to pay (1) $1,000 to the company to buy the shares, and (2) withholding tax on the $50,000 of income (e.g. 22% federal + 8% state = $15,000)
The remaining 1,000 shares Tiffany has after exercising (and paying withholding tax) are put into her brokerage account, and have a cost basis of $51/share
If Tiffany then:
Sells all 1,000 shares at $51 the same day -> No gain or loss occurred; no taxes due
Waits 1 year, then sells all 1,000 at $51 -> No gain or loss occurred; no taxes due
Taxation Examples
Background: John, an employee at AI-Botzilla (a private company), exercised 10,000 vested NSOs with a $1 per share strike price. The current 409a valuation is $5 per share.
Exercise Date and Share Sales Taxation:
To exercise the NSO, John needs to pay (i) AI-Botzilla $10,000 to buy the shares and also (ii) pay AI-Botzilla the required tax withhold (~$14,000 if you assume a 30% all in withholding on the $40,000 of ordinary income realized)
Post exercise, John owns 10,000 with a $5 per share cost basis
Because AI-Botzilla isn't publicly traded, John can only hold the shares for now. If a liquidity event occurred in the future, this is when John could sell shares. If shares were sold, John would realize a short- or long-term capital gain or loss (depending on the amount of time the shares were held and the selling price)
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