3618 / What are NQSOs and how are they taxed?

Tax Implications for Employees

The tax implications of an NQSO are governed by IRC Section 83, and potentially by Section 409A, because they give a participant a legally binding right to compensation that will be realized in a later taxable year. Final regulations to Section 409A allow an NQSO to be structured to claim the equity plan exception and avoid Section 409A coverage. The requirements to claim the regulatory exception from Section 409A coverage are:

the option stock must be Section 409A “service recipient stock;”

the exercise price must be at fair market value on the option grant date;

the option share total must be fixed on the grant date;

the option stock must be subject to taxation under Section 83 and Treasury Regulation Section 1.83-7; and

the option cannot provide for any additional deferral of compensation features.

If an option does not meet these preconditions, and is issued below fair market value, it must comply with Section 409A, which usually destroys the intended objective and subjects the award to immediate 409A taxation with penalties. Fortunately, the IRS has provided for a correction method for such failures that allows the participants to avoid experiencing the 409A taxation scenario if the error is discovered early and corrected quickly ( Q 3541).