How to avoid paying double tax on employee stock options

Anyone who participates in an employee stock option or stock purchase plan at work could overpay their taxes — perhaps by a lot — if they don’t understand a reporting requirement that took effect in 2014.

Under the requirement, all brokers must report cost basis on Form 1099-B for stock that was both acquired and sold on or after Jan. 1, 2014, through an employee stock option or purchase plan in a way that could result in double taxation, unless the employee makes an adjustment on Form 8949. The new requirement does not apply to restricted stock awarded to employees.

“It’s very confusing and scary,” says Barbara Baksa, executive director of the National Association of Stock Plan Professionals. “The important thing is not to assume that the cost basis reported on Form 1099-B is correct. You have to have confidence in your understanding of how this works to report the adjustment and not be afraid the IRS will treat it as a mistake on your part.”

Stock compensation is common in the Bay Area, especially in tech. Employees who sold company stock last year should begin receiving their 1099s in mid-February. The IRS has not gone out of its way to warn taxpayers about this ticking time bomb. Employees should pay close attention to everything they get from their employer and brokerage firms and strongly consider consulting a tax professional.

The details

Brokerage firms use Form 1099-B to report the sale of stock and other securities to customers and the IRS. Cost basis is what you paid for the stock, including commissions. Proceeds are what you got from the sale, after commissions.

In a normal stock sale, the difference between your cost basis and proceeds is reported as a capital gain or loss on Schedule D. End of story.

However, stock acquired under an employee option or purchase plan is different. At least some of your profit is considered compensation and taxed as ordinary income. It will be included as wages, in box 1 of your W-2 Form. But the sale also must be reported on Schedule D.

And therein lies the rub: Unless you adjust your cost basis, by adding in the compensation component, that amount will be taxed twice — as ordinary income and a capital gain.

From 2011 through 2013, brokers had the option of making this adjustment for the employee and reporting the correct cost basis on Form 1099-B. And most did.

Under the new rules, brokers cannot make this adjustment on shares acquired on or after Jan. 1, 2014, through an employee stock option or purchase plan. They can only report the unadjusted basis, or what the employee paid for the stock. To avoid double taxation, the employee must make an adjustment on Form 8949.

Warning: Do not use the box labeled “1g Adjustments” on Form 1099-B to make this adjustment; that is for something else entirely. The information needed to make the adjustment will probably be in supplemental materials that come with your 1099-B.

Stock option example

Let’s start with a simple example: Say you were granted an option to acquire stock in your company at $10 per share. (We will assume this is a nonqualified option; incentive stock options are a bit different but also fall under the new requirement.)

When the stock is at $30, you exercise your option and simultaneously sell the stock. You have a gain of $20. All of it is ordinary income.

“The company will withhold tax and report that $20 on your W-2 as income. The broker will issue a 1099 for the sale. It will include a cost basis of $10, what you paid for the stock. But your basis is really $30,” Baksa says.

To avoid paying tax on that $20 twice, you must make an adjustment on Form 8949.

What happens if you exercised the option in 2014, when the market price is $30, but hold onto the stock and sell it for $40 in 2015?

In this case, $20 will be added to W-2 for 2014, but you won’t get a 1099-B for 2014.

For 2015, you will get a 1099-B showing $10 in cost basis and $40 in sales proceeds. To avoid double taxation on the $20, you must make an adjustment on Form 8949. The remaining $10 will be taxed as a capital gain.

For shares acquired under an employee stock purchase plan, the adjustment depends on how long you hold the stock after purchase. The scenarios are too complex to give examples at this point.

Differing treatment

Note that the new rules apply only to stock acquired in 2014 or later under these plans. It’s not clear what acquired means. Some brokerage firms are using the date a stock option was granted as the acquisition date; some are using the date a stock option was exercised. For stock purchase plans, the acquisition date is usually the purchase date, Baksa says.

In any case, for stock that was acquired under one of these plans before 2014, brokers have the option of reporting the right basis (adjusted) or the wrong basis (unadjusted). Not all brokers are reporting it the same way.

For consistency, some brokers, including E-Trade and Fidelity, will report the unadjusted basis for all shares sold in 2014 under these plans regardless of when they were acquired. Fidelity will include adjusted basis in a supplemental document.

Charles Schwab is taking one approach for stock options and another for stock purchase plans. It notes that options usually do not vest, or become available for sale, for at least one year after the grant date. As a result, very few customers sold stock in 2014 that was also granted in 2014. So for 2014, it will report adjusted basis for all shares acquired through options. For 2015 and thereafter, it will report unadjusted basis for all option shares.

For shares acquired under employee stock purchase plans, however, Schwab will report unadjusted basis for all shares, regardless of when they were acquired.

Intuit, the maker of TurboTax, says employees who use its tax-preparation software will be able to make the correct adjustments through the interview process. “Regardless of how the broker reports it, we are going to get it right,” says Bob Meighan, a vice president with TurboTax.

No adjustment needed

Bruce Brumberg, founder of Mystockoptions.com, said most people who sold stock acquired through option or purchase plans will have compensation income and need to make an adjustment on Form 8949 (unless the broker has made the adjustment). The only times they would not have compensation, and not need to make an adjustment, is if they:

•Exercised an incentive stock option and held it long enough to get a qualifying disposition (at least two years from grant date and one year from purchase).

•Exercised an incentive stock option and sold the stock for less than they paid.

•Sold stock acquired through a purchase plan for less than the purchase price in a qualifying disposition.

Restricted stock

The new reporting requirements do not apply to restricted stock. Employees pay nothing for restricted stock. When it vests, the entire value on the vesting date is treated as compensation and added to their W-2 for that year.
Suppose an employee gets restricted stock that is worth $1,000 when it vests and $1,500 when it is sold. The $1,000 is treated as compensation and added to the employee’s W-2.

When the stock is sold, the broker will send a 1099-B showing sales proceeds of $1,500. It has never had to provide a cost basis on the 1099-B, and still doesn’t. Some might provide a cost basis and if they do, it is usually the adjusted basis, which is $1,000.