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Let's use a hypothetical example. They gave you $100 on the exercise of your option. They didn't withhold any taxes and they didn't report the $100 on your W-2

but that's the thing - they did withhold ordinary income taxes (~39% in total) on my NSO exercises. They only sent me a check for the net after these taxes. They also did report it on my W-2.

Had they done things correctly, they would have given you $80, and reported $100 on your W-2.

For every $100 in gross profit on the exercise, I only received $61. (I'm not complaining just trying to be clear) Are you saying for every $100 they should have given $41 (61 - this 20 extra)?

you have an extra $20 in your pocket that "belongs" to the IRS
The only way I can imagine owing another 20% is if either:
a) A person in the 25% fed tax bracket should only receive 41% of gross profits on NSO option exercises.
b) This is a penalty for some some error causing an extra 20% tax beyond ordinary payroll taxes.

I'm not trying to be difficult, I just think I'm not explaining this well...

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