Filing taxes for stock options and equity compensation can be deceptively tricky. In addition to your W2, you might receive numerous other forms like: Form 1099-B, 3921 and 3922. Worse yet, these forms can be incomplete (and possibly incorrect!) leading to the potential for tax reporting errors. Let’s dig into the top three errors to avoid with stock options and equity compensation.
Mistake #1 – Forgetting to Report Stock Option Sales on Your Return
This is a common error that we see from clients receiving stock options for the first time. Often there is confusion because clients might have immediately sold their stock options right after the shares were vested / exercised. Since clients see these amounts reported on their paystub, they often call it a day and assume that since the IRS already received this information (and withholding tax) that their tax reporting job is done.
Until an IRS notice comes calling later that year…
Even though you are taxed on the receipt of your shares through payroll, the IRS requires you to report the sale of the shares as well. This reporting takes place on Schedule D of the return (as well as the related sub schedules Form 8949). Before you ask: No, you aren’t taxed twice on your shares. The IRS only taxes you on the gain on your shares.
Let’s look at an example:
Sally vests 100 shares of Amazon Restricted Stock Units (RSUs). The value is included in her paycheck at $135 per share. She places an order to sell these shares immediately and the order closes at $136 per share. Sally is taxed on $1.00 gain / share for $100 gain. At a 24% marginal tax rate, she might pay $24 in additional tax on the sale.
Mistake #2 – Calculating the Incorrect Gain (or Loss)
Now that we know we need to report the sale of shares, where do we get the information? The good news is that you should receive Form 1099-B to report the sales proceeds on your tax return. The custodian of the stock will issue this form (generally in February). You’ll need to report the acquisition date, the date of the sale, the sale proceeds and your “cost basis” to calculate the gain.
Your cost basis is the value for what you “paid” for the stock. In the case of stock options, this generally equates to the fair market value of the shares when you received them. This is the same value that is taken into account through your payroll. By including this full value, you ensure that you aren’t double taxed on the shares.
So why is this the second most common error that we see? Well, it turns out that custodians are not allowed to report the cost basis of shares correctly when cash was not exchanged to purchase the shares. These are called “non-covered securities” in IRS language and they lead to a ton of problems come tax reporting time. Oftentimes, the cost basis will be reported at $-0- and clients will pay double tax on their shares!
Most custodians will issue a supplementary schedule in addition to Form 1099-B. The supplemental schedule will provide your additional cost basis information to ensure that you aren’t double taxed on your stock options. (Morgan Stanley issues a separate schedule for instance, while Fidelity makes it a part of the 1099-B reporting package.)
Mistake #3 – Forgetting to Calculate Alternative Minimum Tax (AMT)
Potentially a devastating mistake if you have exercised Incentive Stock Options (ISOs) is forgetting about the impact of the Alternative Minimum Tax.
The AMT is a parallel tax universe where you are taxed on the value of ISOs exercised even if you haven’t sold them. You generate AMT income if the valuation of the stock options (the 263a price) is more than your exercise price.
AMT can apply when you hold your shares and have not sold them in the year you exercised.
It’s important to plan for AMT ahead of time and know the impact to your tax situation before you exercise shares. With careful planning, AMT can be reduced or eliminated by making smart tax moves before and after exercise. When in doubt, be sure to contact a professional tax preparer with experience in stock options.