Nonqualified Stock Options: Tax Withholding on Former Employees

Nonqualified Stock Options: Tax Withholding on Former Employees

Taxable compensation from a former employee’s nonqualified stock option (NQO) generally remains wages when it relates to employee services. Before processing an exercise, confirm the taxable event, withholding method, available cash and reporting obligations. Departure from the company does not remove those obligations.

How NQO Taxation Works

For a typical NQO that was not taxable at grant, exercise into vested shares generally produces ordinary compensation income equal to the stock’s fair market value (FMV) minus the exercise price—the bargain element. If the purchased shares remain nontransferable and subject to a substantial risk of forfeiture, income generally arises when those restrictions lapse, unless a timely Section 83(b) election applies. With that election, the transfer-date spread is generally included in income instead. See IRC §83(a)–(b) and Treasury Regulation §1.83-7.

Example: Assume the NQO was not taxable at grant and the shares are vested at exercise. An employee exercises 1,000 shares at $1 per share when FMV is $5 per share. The $4,000 spread (1,000 × ($5 – $1)) is compensation income in the exercise year, even without a sale. Early exercise into unvested shares requires the separate Section 83 analysis above.

This is different from incentive stock options (ISOs), which can receive more favorable capital gains treatment if the applicable requirements are met. For NQOs, identify when compensation becomes taxable under Section 83 and apply withholding at the appropriate time; exercise is not invariably the taxable event.

Withholding for Current Employees

Taxable NQO exercise income attributable to employee services is generally supplemental wages. Under IRS Publication 15, section 7, the 22% flat method is optional for separately identified supplemental wages within the $1 million annual threshold, and is available only if the employer withheld federal income tax from regular wages in the current or immediately preceding calendar year. The aggregate method is also permitted; if that prior-withholding condition is not met, use the aggregate method. Supplemental wages above $1 million are subject to mandatory 37% withholding on the excess in 2026, counting payments from businesses under common control. Withholding is a prepayment, not the employee’s final tax rate.

Taxable NQO compensation attributable to employee services is generally subject to Social Security and Medicare (FICA), with the applicable wage base and thresholds. For a typical NQO exercised into vested shares, compensation and the related withholding generally arise at exercise. Early exercise into unvested shares requires the Section 83 analysis above. A broker’s remittance from sale proceeds funds withholding; a later stock sale is not generally what triggers the wage income.

For current employees, arrange cash funding for withholding, either from the employee or, where available, from a broker-assisted stock sale. Reducing the shares delivered does not itself provide cash for a tax deposit. Report the taxable compensation and withholding on Form W-2.

The Former Employee Withholding Problem

Former employees present an entirely different challenge. The person has already left the company, is no longer in the payroll system, and may be in a different state or even a different country. But if they exercise an NQO years after departure, the tax withholding obligation hasn't disappeared — it's simply become harder to administer.

A former employee’s departure does not, by itself, remove wage withholding on taxable NQO compensation attributable to their employee services. Determine the character of the compensation from the services to which the option relates; do not treat every option holder as an employee or every former employee as a contractor.

The timing problem is real, though. A company's payroll system may not easily accommodate a one-time withholding event for someone who isn't an active employee. The person may be difficult to locate or uncooperative about providing withholding instructions. These are operational challenges, but they don't eliminate the legal obligation.

How to Handle Withholding for Former Employees

The steps and withholding examples below assume a domestic employee option that was not taxable at grant and is exercised into vested shares. For an early exercise into unvested shares, determine the Section 83 income-inclusion date and amount, including the effect of any timely 83(b) election, before applying these steps. A qualifying Section 83(i) election can defer federal income taxation and related income-tax withholding, but does not defer FICA; separate rules apply. Cross-border services or residence also require separate analysis.

Step 1: Calculate the bargain element. For a typical NQO exercised into vested shares, calculate the spread using the stock’s FMV on the exercise date, not the date the employee first gives notice. For an early exercise into unvested shares, use the valuation date required by Section 83, taking account of any timely 83(b) election. Document the value and supporting facts as of that date. An earlier appraisal does not automatically establish the taxable-date value: consider intervening financings, acquisition developments and other material changes. One potential source of valuation evidence is an existing 409A valuation.

Step 2: Calculate withholding due. Determine whether the optional 22% method is available and selected, or whether to use the aggregate method described above. A former employee who has had no federal income tax withheld from this employer’s regular wages in the current or immediately preceding calendar year does not qualify for the optional flat method. Apply mandatory 37% withholding to supplemental wages exceeding the $1 million annual threshold, including the required common-control aggregation. You also need to withhold FICA taxes: Social Security at 6.2% (up to the annual wage base, which is $184,500 for 2026) and Medicare at 1.45% (no limit). You must also withhold the 0.9% Additional Medicare Tax once the wages you pay that person cross $200,000 for the calendar year — counting wages paid before termination and any predecessor wages a qualifying successor must include — regardless of filing status, and with no employer match (26 U.S.C. §§ 3101(b)(2), 3102(f)). The $50,000 spread in the example below doesn't reach it; a $2 million spread does. Check both the former employee’s residence and where the services underlying the option were performed. Moving to Washington does not eliminate another state’s claim to compensation sourced there. California, for example, taxes a nonresident’s NQO compensation to the extent attributable to California services; see California FTB Publication 1004, section C. Determine the allocation and employer withholding obligations under each relevant state’s rules rather than relying only on the employee’s current address.

Example: Assume the optional 22% method is available and selected, total supplemental wages remain within $1 million, and the former employee has received no other wages from this employer during the current year. The former employee, in Washington State, exercises options with a $50,000 bargain element. Federal income tax: $11,000 (22%). FICA (Social Security): $3,100 (6.2%). Medicare: $725 (1.45%). Total federal withholding: $14,825. Washington has no income tax on wages (until ESSB 6346 takes effect January 1, 2028, imposing a 9.9% tax on income above a $1 million standard deduction); this 2026 example assumes the compensation is not taxable by any other state and no other state requires withholding. Washington residence alone does not establish those assumptions. If the full $50,000 is subject to California personal income tax withholding and the applicable stock-option supplemental method is used, the California personal income tax withholding would be $5,115 (the 10.23% flat rate for stock options and bonuses in EDD Information Sheet DE 231PS). This amount excludes any other applicable California payroll taxes.

The 22% optional and 37% mandatory supplemental withholding rates are statutory-rate rules, not automatically inflation-adjusted percentages. The Social Security wage base is updated annually. Confirm the applicable year and withholding method before using the example. See IRS Publication 15, section 7.

Step 3: Arrange cash funding for withholding. Require the former employee to deliver cash for withholding, or arrange a broker-assisted sale that remits sufficient cash to the company. If the plan permits net exercise or share withholding, document the arrangement and identify how the company will fund the required cash tax deposits. Retaining shares does not itself remit tax to the IRS. Confirm funding before exercise without delaying a deposit beyond its legal deadline.

Step 4: Report the compensation on Form W-2. Report taxable NQO compensation attributable to employee services on Form W-2 for the year of income inclusion, even if the recipient no longer works for the company. Include the required wage, withholding and Code V information. If an already-filed W-2 omitted or misstated the compensation, follow the IRS correction instructions for Forms W-2c and W-3c; do not assume that an additional unmarked W-2 corrects the original.

Step 5: Deposit and report the payroll taxes. Deposit required federal income-tax withholding and employee and employer FICA under the applicable deposit schedule. Report the amounts on Form 941 for the relevant quarter unless a different employment-tax return applies. A quarterly return deadline is not the deposit deadline. See IRS Publication 15, sections 11–12.

FICA Considerations and the Wage Base Cap

Social Security tax has an annual wage base cap. For 2026, the cap is $184,500. This means that once an employee's wages (including NQO bargain elements) exceed the cap in a calendar year, no additional Social Security tax is withheld.

For withholding purposes, the Social Security wage base generally applies separately to each employer. Wages from an unrelated new employer do not reduce your company’s withholding; the employee generally claims excess Social Security tax from multiple employers as a credit on their income tax return. Medicare has no wage cap: withhold 1.45%, plus 0.9% Additional Medicare Tax on wages above $200,000 in the calendar year, regardless of filing status. A qualifying successor employer must include predecessor wages when applying both the Social Security wage base and the $200,000 Additional Medicare withholding threshold. See IRS Publication 15, section 9. The employee reconciles Additional Medicare Tax on their income tax return.

For a former employee with no other wages from your company during the year and no predecessor wages that must be counted, withhold 6.2% Social Security tax on the bargain element up to the wage base.

Contractor vs. Employee Distinction

What if the person exercising the NQO was actually a contractor, not an employee? The withholding rules are different. NQOs granted to contractors have complex tax treatment, and the company doesn't have automatic withholding authority the way it does with employees.

For an option attributable to independent-contractor services, the company generally reports taxable compensation on Form 1099-NEC rather than Form W-2, subject to the applicable reporting rules. Employee wage withholding generally does not apply. However, when backup withholding is required—for example, because the payee has not supplied a required correct taxpayer identification number—the payer must withhold and remit 24%. It is not enough to leave that obligation to the contractor. See IRS backup-withholding guidance.

This is messier from a compliance standpoint. It's better to clarify at the grant whether the person is an employee or contractor, and if they're a contractor, be aware that NQO exercises carry additional risk and complexity.

Penalty Exposure for Non-Compliance

What happens if a company fails to withhold or fails to deposit withheld taxes? The consequences can be significant.

The employer can be liable for required withholding under IRC §3403. Separately, the trust fund recovery penalty under IRC §6672 requires both responsibility for collecting, accounting for or paying over the tax and a willful failure to do so (or a willful attempt to evade or defeat the tax or its payment). A responsible title or payroll role alone is not sufficient. When applicable, the penalty equals the unpaid trust fund tax; it can reach responsible individuals, not just the company. Other penalties and interest may also apply.

Under IRC §6656, failure-to-deposit penalties generally equal 2% of the underpayment when 1–5 days late, 5% when 6–15 days late, and 10% when more than 15 days late. The rate is 15% if the tax is not deposited on or before the earlier of 10 days after the first delinquency notice under §6303 or the date of an immediate notice and demand under the provisions specified in §6656(b)(1)(B). Penalty relief if you had a good excuse, and other available relief, can affect whether a penalty applies; these percentages are not automatic in every case.

There's also reputational risk. If a company is regularly non-compliant with NQO withholding, employees and former employees may become wary of exercising options. This undermines one of the key benefits of equity compensation.

Step-by-Step Practical Guide for a Former Employee Exercise

Here's a checklist for handling a former employee NQO exercise from notification to W-2 reporting:

Upon notification:

• Confirm the person's identity and that they hold unvested or vested options.
• Request a current mailing address, email, and phone number.
• Check this employer’s calendar-year wages and any predecessor wages that a qualifying successor employer must count when applying the Social Security wage base and Additional Medicare withholding threshold. Wages from an unrelated new employer do not reduce this employer’s withholding obligation.
• Request the current address, residence history and locations where services underlying the option were performed. Retain workday and employment records needed to allocate compensation under each relevant state’s rules.

Before processing the exercise:

• Determine and document FMV on the applicable Section 83 valuation date—generally the exercise date for vested shares. Before relying on an earlier appraisal, assess intervening events and whether it supports value on that date.
• Calculate the bargain element.
• Calculate federal income tax withholding using the permitted method: optional 22% only when its conditions are met, otherwise the aggregate method; apply mandatory 37% to supplemental wages above $1 million, with required common-control aggregation.
• Calculate FICA withholding (check wage base cap for Social Security).
• Determine which states can tax the compensation based on residence and service location, allocate the income as required, and calculate employer withholding under the applicable state rules.
• Prepare a written exercise agreement or confirmation identifying the withholding calculation and cash funding source. If using net exercise or share withholding, document how the company will fund the tax deposits.
• Provide the total withholding amount to the former employee and request their election.

At exercise and by the applicable deposit deadlines:

• Process the exercise in the equity management system.
• Generate share certificates or electronic documentation of ownership.
• Deposit withheld federal and state taxes with the appropriate agencies (IRS, state). Accumulating $100,000 or more in employment taxes during a deposit period generally requires a deposit by the next business day—even for a monthly depositor. Do not wait for the quarterly return or for the former employee to supply cash.
• Retain all documentation (exercise agreement, withholding calculation, payment records).

By the applicable Form W-2 furnishing and filing deadlines:

• Prepare and mail a W-2 to the former employee showing the bargain element as wages and all withholding.
• File Copy A of the W-2 with the Social Security Administration.
• Retain a copy for company records.

Best Practices Going Forward

To minimize compliance risk, consider these practices:

Clarify in advance. When granting options, explain the obligation to fund applicable withholding when option compensation becomes taxable, whether the recipient is a current or former employee. Address early exercise and Section 83(b) elections if the plan permits unvested-share purchases.

Maintain equity records. Keep detailed records of all option holders, vesting schedules, exercise prices, and grant dates. When a person leaves, maintain their contact information and option records indefinitely. You may need this data years later when they exercise.

Use a third-party administrator. An equity administrator can help with exercise processing, but payroll calculations, Form W-2 reporting and tax deposits may require a separate payroll provider. Confirm each provider’s contracted duties, deadlines and funding arrangements. Outsourcing generally does not relieve the employer of its employment-tax obligations. See IRS Publication 15, section 16.

Educate employees at grant and termination. At grant and termination, explain the potential tax and withholding consequences of exercise. A typical post-employment exercise into vested shares produces wage income, while an early exercise into unvested shares requires separate analysis. Explain how any required withholding will be funded.

Automate withholding calculations. Use a spreadsheet or software tool that automatically calculates withholding based on FMV, exercise price, wage base, and tax rates. Manual calculations are error-prone.

Conclusion

NQO compensation attributable to employee services generally remains wages when a former employee exercises. Leaving the company does not eliminate the employer’s withholding obligations. Confirm the taxable event, the permitted withholding method and applicable employment taxes, then collect, deposit and report the amounts correctly. Options attributable to contractor services follow different reporting and backup-withholding rules.

Agree on the withholding funding and reporting process before the exercise. Keep the calculation, payment records and filed forms together so the company can explain what it collected, deposited and reported.