Exercising an NQO: The Tax Math

Exercising a stock option is not always as straight forward as you might expect. The reason? Taxes.

When you exercise a nonqualified stock option (an "NQO"), and there is a "spread," you have to pay income and employment taxes in addition to the exercise price to exercise your options.

“Spread” means the positive difference between the fair market value of the stock underlying the option and the strike price.

Let’s do a math example. Suppose you have a nonqualified stock option to purchase 50,000 shares at a strike price of $0.05 per share. The current fair market value of the common stock is $3.75, according to the company’s latest Section 409A calculation. Meaning, the spread is $3.70 a share.

If you exercise your option in full, you will have to write a check for 50,000 x $0.05, for the strike price – for a total of $2,500.

However, when you exercise a nonqualified stock option, not only do you have to pay your employer the exercise price per share, but you also have to pay your employer the employee tax withholding due. This includes your income tax withholding and employee side FICA.

Thus, you will also have to pay the company an amount equal to the income tax and employee‑side FICA tax withholding on the spread. The “spread” here is 50,000 shares x (3.75 – 0.05), or 3.70 per share x 50,000, or $185,000. Income and employee‑side FICA on $185,000, assuming you are over the FICA cap, is going to be approximately $48,932.50. (This according to Randy Harris, payroll consultant (@getthepayroll). Thank you, Randy!, calculated as follows:

$185,000 x 25% (supplemental withholding rate for pay under $1 million) = $46,250 $185,000 x 1.45% (Medicare tax) = $2,682.50 $46,250 + $2,682.50 = $48,932.50

(Warning: Randy and I did this math a little while back--last year I think--and the exact withholding has probably changed by now.) 

But watch out, annual earnings over $113,700 will be exempt from the Social Security Tax of 6.2% BUT due to the Affordable Care Act, as of January 1, 2013, income over $200,000 will require an additional 0.9% Medicare Tax Withholding.

In addition, please see the attached link for a breakdown of tax rates applicable to other situations, and be sure to consult your accountant/advisor for specifics:  2013 Fast Wage & Tax Facts.

Finally, also be aware that this tax withholding satisfies the employer’s obligations, but may not satisfy the employee’s tax obligations in full. That depends on the employee’s other tax items. The employee may need to make additional tax deposits to avoid an underpayment penalty. The optionee should consult with his or her own tax advisor on this issue.

State Income Tax Consequences

This blog post doesn’t address potential state income tax withholding issues.

Conclusion

When you are planning to exercise, consult your company’s chief financial person. He or she can help you work through the tax math of the exercise. The numbers change on a regular basis as Congress modifies or changes the supplemental wage withholding rate.