John M. Hoffman & Associates CPAs

Frequently Asked Tax Questions

Stock Options

Non Qualified Stock Options (NQUAL) 

“How do I exercise my NQUAL options? I don’t know if I have enough money to even do that."

In most cases you don’t need any money to exercise NQUAL options. They are exercised in a “cash-less” fashion.

Lets assume you have the option to buy 5,000 shares of IBM at a price of $70. Let’s assume that the price of IBM is $100 today. Our quick math tells us that there is a $30 profit in each of those shares today. If the stock was trading at $60 today, the option would have no immediate value and you would have no reason to exercise the option and pay $70 when you could instead buy the stock on the open market for $60. This is one reason that people let their options expire – because they become worthless.

In our example, however, there is an inherent value of $30 per share and you want to cash out that profit on all 5,000 shares. You wonder why you might be exercising these options today?

 So you contact your employer and inform them that you wish to do a “cash-less” exercise for all 5,000 shares. What happens next is that the company delivers 5,000 shares to the brokerage institution they work with who then sells the 5,000 shares. In our example the shares are sold at $100 each, or $500,000 in total. Let’s assume that the brokerage and other fees take $400 out of the $500,000 netting $499,600 on the sale of your shares.

From the $499,600, the company subtracts the option price of $70 per share, in this case $350,000. That leaves the remaining $149,600 as your “profit”. This money is almost yours but first, it must be subjected to withholding.

The broker told the employer that the stock was worth $500,000 and your option cost was $350,000, and accordingly your compensation was to be $150,000. Your employer will withhold social security, Medicare, federal and state taxes from this $150,000. Let’s assume that these taxes add up to 40%, or $60,000. This $60,000 is taken out of the $149,600 and you are given a check for $89,600.

Your employer will add $150,000 to your W-2 as well as the $60,000 of taxes withheld.

You might wonder; what about the difference between the $150,000 and the $149,600? That is the cost of you selling those shares. Because your W-2 is going to be based on the $150,000, we need to recoup tax wise that $400.

The brokerage company sends you and the IRS (we hope they actually send it – some companies like E*Trade wait for you to go and download it as they assume you know to do this), a 1099 reporting $499,600 of sales in IBM shares.

Often times employees assume that since the profit from the option is already in their W-2, there is nothing else to report. Not true. You need to complete the loop on the sale of the 500 shares netting $499,600. This is simple, so long as we have all the paperwork (which every company that we have ever seen has always issued it – that does not mean that every employee can easily put their hands on it). Your cost basis for the shares is the $350,000 that you paid for them plus the compensation you include from the transaction of $150,000. Accordingly you report a $500,000 cost basis for the same day sale at $499,600, resulting in a $400 short term loss, and that is where we account for that difference.

You may also think that the taxes have already been paid on the options. You would be sort of right but not exactly. What is more accurate is that taxes have been withheld from the transaction but that does not mean that the correct amount was withheld. The ultimate tax on the transaction depends on your own tax situation, but at least you have the withheld amounts to go towards that tax.