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Subject:   nqso
Date:   Mon, 28 Feb 2005
From:   Wendy

Hello Mike,

Thanks for a very informative site. My question is in regards to NQSOs.

My husband exercised 5,000 options at the end of 2004. I know we have to pay tax on the difference between the value of the options when he was issued them and the value of the stock at the time of exercise and sale, but does he also have to pay taxes on the value of the options at issue at the same time? To explain it better:

2004 stock value at the time of exercise and sale @ $52 per share,	520,000
2001 stock option grant of 10,000 shares at $22 per share,	220,000

Taxable gain is $300,000. Do we also have to include the $220,000 as ordinary income?

My accountant says yes, but my husband's panicked colleagues are saying that's impossible.

Thanks,
Wendy

Answer

Hello Wendy,

If I'm understanding you correctly, here's how this works. I'm assuming you didn't come up with any cash to exercise the options. The exercise price was paid from the proceeds of the sale. That means you received $520,000 - $220,000 less any taxes withheld.

The ordinary income that should have been included in your husband's W-2 wages is $300,000. The tax basis of the shares sold to be reported on Schedule D (assuming you received a 1099-B for the sale) is $220,000 (option price) + $300,000 (additional wages) = $520,000. The only way the $220,000 option price would be taxable is if the employer gave you the money to exercise the option.

Good luck!

Mike Gray

For more information about non-qualified stock options, request our free report, Non-Qualified Stock Options - Executive Tax and Financial Planning Strategies.

IRS Circular 230 Disclosure: As required by U.S. Treasury Regulations, you are hereby advised that any written tax advice contained in this answer was not written or intended to be used (and cannot be used) by any taxpayer for the purpose of avoiding penalties that may be imposed under the U.S. Internal Revenue Code.