The Basics of Nonqualified Stock Options and Capital Gains

In this video, we’ll take a look at nonqualified options and how they work with capital gains. Simply put a capital gain is when you sell shares at a price that is higher than what you paid for them. The IRS considers this income and will tax it. However, there is a potential benefit. If you sold the stock a year after you made the purchase, then the gain will be taxed at a lower rate.

The maximum is 20%. And yes, this is often lower than the tax rates for your regular income like salary. This is why when it comes to taxes people look for ways of getting capital gains. However, with a nonqualified stock option, you do not get this preferential treatment– that is, at least for when you exercise the option.

OK, so let’s take an example with Cool Corp. Suppose you exercise an option and own 100 shares of the company at $10 each. At the time the stock price was at $25 a share. So your bargain element for this would be $1,500. This is the $2,500 amount realized, which is $25 multiplied by 100 minus the cost basis, which is $1,000 or $10 multiplied by 100 shares.

Then after two months go by, you sell the shares since the stock price is now at $30 a share. But what about the gain on this transaction? Interestingly enough, it may not be what you think. Actually, this is quite common when it comes to taxes. Unfortunately, the rules can get complicated and sometimes not even make much sense.

But let’s see how this works. In our example, to calculate the gain on the sale of your 100 shares we need to add back the bargain element of $1,500. In other words, we add it to the cost basis. By doing this, we’re making it so we do not have to pay a double tax. Seems a bit confusing.

It does. So let’s go further with our example to get a clearer explanation of all this. When you sell the 100 shares, the total amount realized will be $3,000. This is the $30 stock price times 100 shares. But the cost basis has the following calculation.

First of all, we have the initial purchase. This is what we paid to exercise the stock, which was $1,000, or $10 times 100 shares. Then we added the $1,500 bargain element. This gives us a total cost basis of $2,500, or $1,000 plus $1,500. Then to determine our capital gain we take the amount realized and subtract the cost basis.

This is $3,000 minus $2,500, which gives us a gain of $500. So you see if we did not add the $1,500 bargain element, you would have paid a much higher tax. Keep in mind it is fairly common for people to not include the bargain element, which means missing out on a key tax break. Even tax professionals miss out on this from time to time. So make sure you don’t.

However, in terms of the tax rate, you’ll pay the rate you would on your salary or other ordinary income on the $500 gain since it is a short-term capital gain. But if you waited for more than a year it would have been at the more favorable capital gains rate of 20%. Not to be alarmist, but it is important to understand that there is a potential big risk when exercising nonqualified stock options.

Here’s the scenario. Cool Corp. has had a big run. It is now at $110 per share. You decide to exercise your option to purchase 1,000 shares at $10 each generating a profit of $100,000. Great right? Definitely.

But let’s suppose that Cool Corp. has tremendous problems and then the stock plunges to $20 a share. In this situation, you still owe taxes on the $100,000 from the exercise which could easily be $40,000 or more. This would include both federal and state taxes. Granted you will have a capital loss of $90,000 if you sell these shares. But again you cannot use this to offset taxes on the $100,000 you earned from the exercise.

You can only deduct this against other capital gains and then up to $3,000 of any other income per year. In this case, you’ll be in a terrible situation where you owe taxes on essentially phantom gains. Even worse if you do not have enough money to pay the taxes, you’ll need to work out some arrangement with the IRS and state authorities. This can certainly be a terrible experience. And unfortunately, it is not uncommon.

After all, tech stocks can be extremely volatile. To avoid this situation, it is generally a good idea to make sure you have enough money set aside when you exercise your option to pay for your taxes. This would mean selling a large portion of your stock. Also, you can then diversify this into other investments or make a purchase, such as for a car or even a home.

OK then, we’re now at the end of the video for nonqualified stock options. In the next video, we’ll take a look at incentive stock options.