Nonqualified Stock Options ("NSOs")
Nonqualified stock options are rights granted by your company to purchase shares of the corporations stock at a fixed price for a specified period of time. NSOs are options that do not meet the strict requirements for qualification as Incentive Stock Options under the Internal Revenue Code and thus are not given special favorable tax treatment.
NSOs are taxed in the year of exercise. The amount of income recognized is equal to the difference between your exercise price and the fair market value of the underlying stock at the time of exercise (your bargain element). The bargain element is taxable as compensation income, and you will immediately be responsible for federal, state, and local (if applicable) taxes at the time of exercise. The cost basis for the shares of stock will then be the market value at the time of exercise. When you later sell the stock, the tax treatment will be capital gain (or loss). Since, in general, NSOs are taxed twice (when you exercise the option and again when the stock resulting from the options are sold), NSOs bear a substantial tax burden. Unfortunately, there are limited tax avoidance techniques available to address this burden.