Nonqualified stock options (NQSOs) are also known as nonstatutory stock options. You report nonqualified stock option income differently than you report income from these options:

• Incentive stock options
• Options granted under an employee stock purchase plan

When you receive nonqualified stock options, you usually don't recognize income until you exercise the options. Since you don't have total control over the stock, you'll lose the options if you don’t exercise them within the required time period.

To learn more, see IRS Publication 525: Taxable and Nontaxable Income.

However, if the option has a readily determinable market value, you might have to recognize income when you receive the option. Options traded in an open market, like the New York Stock Exchange, have readily determinable market values.

When you exercise your options, you'll have W-2 income equal to the difference between:

• The option price
• The stock’s fair market value on the date you exercised your options

Your employer will include that amount in the Form W-2 they send you. The amount will be in box 1, and the code "V" will be in box 12.

Since the difference between the option price and the fair market value when you exercised your option is included in your W-2 income, you'll have already paid taxes on it. The basis of the stock is the fair market value of the stock on the date you exercised the options:

    Amount you paid + amount included in your income = fair market value.

As with qualified stock options, you can often do a paperless transaction in which you exercise your NQSOs and sell the stock at the same time. Even though you perform only 1 transaction, it’s really 2 transactions: You exercised your options and then you sold the stock.

Ex: On Dec. 15, 2005, Harriet’s employer grants her an option to buy 100 shares of stock at $10 per share. She must use the options to purchase shares within a stated time period, so the options are restricted.

On April 20, 2007, she exercises her options and purchases the 100 shares of stock. When she exercised her options, the stock’s fair market value was $16 a share. So, her employer will include $600 in the income on her W-2:

    $16 (stock’s fair market value) - $10 (price paid for the stock) x 100 (number of shares) = $600

The basis of her stock is $1,600 ($16 x 100 shares). On June 15, 2008, Harriet sells the 100 shares for $23 per share and receives a check for $2,300. From the sale, she has a long-term capital gain of $700:

    $2,300 (total amount received from the sale) - $1,600 (total basis of the stock) = $700

If Harriet had made a paperless transaction, meaning she exercised and sold her shares at the same time on June 15, 2008, her option is the purchase of 100 shares at $10 per share. To exercise the option, she worked with a brokerage firm who:

1. Paid the company on her behalf for the options
2. Credited her margin account for the sales proceeds

Harriet then reported 2 transactions.

The first is the exercise transaction. When she exercised the options, the fair market value of the stock was $23 a share. So, the brokerage firm will pay $1,000 ($10 x 100 shares) directly to her employer and debit her margin account for the purchase. Then when the shares are sold, the brokerage firm will credit her margin account with $2,300 ($23 x 100 shares).

Her employer will then include $1,300 in the income they report on her W-2:

$2,300 (fair market value of the stock x 100 shares purchased) - $1,000 (option price x 100) = $1,300

The second transaction is the gain or loss. In this case, there's no gain or loss on the sale. The basis of Harriet’s stock is $23 per share, and she sold the stock for $23 per share. However, since she paid $80 in brokerage fees on the sale, she’ll have a loss of $80:

    $2,220 (net proceeds) - $2,300 (basis) = $80 loss