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Nonqualified Stock Options Demand Tax Planning Attention

08.16.2017

Are you applying the proper tax treatment to each fringe benefit you provide? If not, you could face unexpected tax liabilities or other undesirable consequences. Your compensation may take several forms, including salary, fringe benefits and bonuses.

If you work for a corporation, you might also receive stock-based compensation, such as stock options. These come in two varieties—nonqualified (NQSOs) and incentive (ISOs). With both NQSOs and ISOs, if the stock appreciates beyond your exercise price, you can buy shares at a price below what they’re trading for. The tax consequences of these types of compensation can be complex, so smart tax planning is critical.

Compensation income

NQSOs create compensation income taxed at ordinary income rates on the “bargain element,” which is the difference between the stock’s fair market value and the price when exercised. This would apply regardless if the stock is held or sold immediately.

On the other hand, ISOs don't typically create compensation income taxed at ordinary rates unless you sell the stock from the exercise without holding it for more than a year in a “disqualified disposition.” If the stock from an ISO exercise is held for more than one year, then generally, your lower long-term capital gains tax rate applies when you sell the stock.

In addition, NQSO exercises don’t create an alternative minimum tax (AMT) preference item that can trigger AMT liability. ISO exercises can trigger AMT unless the stock is sold in a disqualified disposition. However, it’s possible the AMT could be repealed under the tax reform legislation.

More tax consequences to consider

When you exercise NQSOs, you may need to make estimated tax payments, or increase withholding to fully cover the tax. Otherwise, you might face underpayment penalties.

It's important to keep in mind that an exercise could trigger or increase exposure to the additional 0.9 percent Medicare tax and the 3.8 percent net investment income tax (NIIT). These top rates could potentially be rescinded or reduced as part of the Affordable Care Act repeal, but the future is still uncertain.

If you have any questions about NQSOs or other stock-based compensation, please contact your tax advisor or Kevin Boeving, Principal, Tax Services, at 314.824.5225 or kboeving@bswllc.com.

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