Nonqualified Stock Options: Tax Withholding on Former Employees
One of the trickiest compliance issues in startup equity compensation is handling tax withholding when a former employee exercises nonqualified stock options (NQOs). The obligation to withhold taxes doesn't disappear when the employee leaves the company — but the mechanics become complicated fast. A surprising number of companies either miss the withholding obligation entirely or apply the wrong withholding rules, creating unexpected tax bills and potential IRS penalties.
How NQO Taxation Works
To understand the withholding problem, you need to know how NQOs are taxed. When an employee exercises an NQO, the spread between the fair market value (FMV) of the stock and the exercise price is treated as ordinary income. That spread is called the "bargain element."
Example: An employee exercises 1,000 shares at $1 per share when FMV is $5 per share. The bargain element is $4,000 (1,000 shares × ($5 – $1)). This $4,000 is taxable ordinary income in the year of exercise, whether or not the employee actually sells the shares.
This is different from incentive stock options (ISOs), which can receive more favorable capital gains treatment if holding requirements are met. With NQOs, the ordinary income treatment is mandatory at exercise, and the company must ensure taxes are properly withheld.
Withholding for Current Employees
When a current employee exercises an NQO, the company has clear authority to withhold taxes. The withholding is typically treated as a supplemental wage (not part of the employee's regular paycheck) and federal income tax is withheld at the supplemental wage rate. As of 2026, the supplemental wage withholding rate is 22% (or 37% if total supplemental wages for the year exceed $1 million).
The company also withholds Social Security and Medicare (FICA) taxes on the bargain element. These are mandatory employment taxes. The key is timing: the withholding obligation attaches at exercise, when the bargain element is treated as wages. In a same-day-sale arrangement the broker remits withholding out of the sale proceeds, but that is a funding mechanic — the obligation itself arises at exercise, not at sale.
For current employees, the company can simply require the employee to pay withholding, deduct it from the exercise proceeds, or have the employee deliver cash. The employee receives a W-2 at year-end reflecting all income and taxes withheld. This is straightforward.
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.
Many companies assume that because the person is no longer an employee, they don't have to withhold. This is false. The obligation to withhold federal income and employment taxes applies whenever a person exercises an NQO, regardless of employment status. The IRS does not care whether the person is a current employee or a former employee; the withholding obligation exists either way.
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
Here's a practical approach to managing NQO exercises by former employees:
Step 1: Calculate the bargain element. When the former employee notifies the company of their intent to exercise, calculate the spread between the current FMV (or the FMV on the exercise date) and the exercise price. If the stock is not publicly traded, you'll need a recent 409A valuation.
Step 2: Calculate withholding due. Federal income tax withholding on supplemental wages is 22% (or 37% on amounts exceeding $1 million). 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). Some companies also withhold state income tax, depending on where the former employee is located.
Example: A 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 household income above $1 million), so currently no additional state withholding. If the employee is in California, add another $5,150 (assuming the top marginal rate of ~13.3%).
Step 3: Collect withholding from the exercise proceeds or separately. The cleanest approach is to require the former employee to deliver cash equal to the withholding obligation, or to instruct the company to deduct withholding from the exercise proceeds. Some companies allow a "net exercise" where the company automatically withholds from the shares delivered. Make sure to document the election in writing.
Step 4: Issue a supplemental W-2. At the end of the calendar year in which the exercise occurred, the company must report the bargain element as wages on the former employee's W-2 (or a supplemental W-2 if issued outside the normal W-2 period). The withholding must also be shown on the W-2.
Step 5: Report FICA and Medicare withholding. The company must deposit FICA and Medicare taxes withheld with the IRS. These amounts are reported on the Form 941 (quarterly employment tax return) in the quarter in which the exercise occurred, even though the person is no longer an employee.
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.
One trap here: the wage base applies per employer for withholding purposes. Even if the former employee has already hit the cap through wages from a new employer, your company must still withhold Social Security tax on the bargain element up to the wage base for the wages it pays — the employee recovers any excess Social Security tax as a credit on their Form 1040. (Only a statutory successor employer can count a predecessor's wages toward the cap.) Medicare, by contrast, has no cap, so you always withhold 1.45% (or 2.35% for high earners, depending on income level).
For a former employee who has received no other wages from your company during the year, that means withholding the full 6.2% 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.
If a former contractor exercises an NQO, the company typically issues a 1099-NEC (not a W-2) and the contractor is responsible for self-employment tax. The company has no obligation to withhold. However, the contractor will owe backup withholding (currently 24%) if they fail to provide a valid tax ID or if the IRS has notified the company that backup withholding is required.
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.
Common Mistakes Companies Make
Not withholding at all. Some companies simply ignore the withholding obligation when a former employee exercises, assuming the person is no longer their responsibility. The IRS disagrees. Even if the company doesn't withhold, it can face penalties for failing to deposit withheld taxes.
Withholding at the wrong rate. Companies sometimes apply the wrong percentage — using a regular payroll tax rate (perhaps 12-15%) instead of the 22% supplemental wage rate. This underwithholding creates liability for both the company and the employee.
Forgetting to file a W-2 or supplemental W-2. The most common mistake is not reporting the bargain element on any W-2. Without a W-2, the IRS has no way to match the income to the former employee's tax return, and the employee may not report the income. When the IRS later detects the omission (through third-party information matching), it assesses penalties on both the company and the employee.
Not calculating FICA correctly. Companies sometimes forget that NQO exercises are subject to both Social Security and Medicare tax, or they miscalculate the Social Security wage base cap. This leads to underpayment of employment taxes.
Withholding but not depositing with the IRS. A company might collect withholding from the former employee but then forget to actually deposit it with the IRS. The company remains liable for the full amount, plus penalties and interest.
Penalty Exposure for Non-Compliance
What happens if a company fails to withhold or fails to deposit withheld taxes? The consequences can be significant.
If the company doesn't withhold, the IRS can assess the company for the full amount of tax that should have been withheld (26 U.S.C. § 3403). The penalty for willful non-compliance can reach 75% of the tax due. Additionally, the company is liable for interest, compounded daily, from the date the tax should have been withheld.
If the company withholds but fails to deposit with the IRS, penalties are based on how late the deposit is. A deposit that is 1-5 days late incurs a 2% penalty; 6-15 days late incurs 5%; more than 15 days late incurs 10%. For large withholding amounts, these percentages translate to substantial dollars.
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.
- Request their current W-2 wages for the calendar year (to assess Social Security wage base).
- Request their current address and state of residence (for state income tax withholding, if applicable).
Within one week:
- Obtain a current 409A valuation or stock price (FMV) as of the exercise date.
- Calculate the bargain element.
- Calculate federal income tax withholding (22% standard, or 37% if total supplemental wages exceed $1M).
- Calculate FICA withholding (check wage base cap for Social Security).
- Calculate state income tax withholding, if any.
- Prepare a written exercise agreement or confirmation stating the withholding method (cash payment, deduction from exercise proceeds, or net exercise).
- Provide the total withholding amount to the former employee and request their election.
Upon receipt of withholding:
- 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).
- Retain all documentation (exercise agreement, withholding calculation, payment records).
By January 31 of the following year:
- 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, include language in the option agreement explaining the withholding obligation and that it applies to all exercises, whether by current or former employees. This sets expectations upfront.
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. If your company grants options regularly, consider using a professional equity administrator or plan servicer. They handle the mechanics of exercises, withholding calculations, W-2 reporting, and IRS deposits. The cost is modest relative to the compliance risk.
Educate employees at grant and termination. At the time of option grant, explain the tax consequences of exercise. At termination, remind the person that withholding will be due if they exercise post-employment. A clear, written explanation reduces surprises and disputes later.
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 withholding for former employees is often overlooked, but it's a critical compliance obligation. The rule is straightforward: whenever anyone exercises an NQO, the company must withhold income and employment taxes, regardless of employment status. The challenge is execution — former employees are outside the payroll system, and the company must establish a process to handle the withholding correctly.
The cost of getting it wrong is high: IRS penalties, interest, reputational damage, and potential employee friction. The cost of getting it right is low: a bit of planning, calculation, and documentation. For any startup with an active equity plan, this is a worthwhile investment in compliance.
