Employer stock plans made simple

March 26, 2015

So your employer offers a stock plan that allows you to purchase shares in the company at a steep discount, or receive stock at no cost to you at all. Seems like a great deal–and usually is–but these plans are often a source of a lot of headaches and even costly mistakes at tax time. Well this post is not going to get into all the different types of stock plans out there or all the different ways they are handled (the title says “made simple”), but I do want to offer a simple approach that applies to the vast majority of employer stock plans and should help you avoid very costly mistakes.

Here’s the simple approach…read on to see if this applies to you: In most cases, when you exercise employer stock options, you’ll have proceeds from a sale reported to you at the end of the year. It may appear at first that you’re being double-taxed on the exercise of stock options. In fact, you simply need to report the sale with cost basis equal to proceeds (i.e. no gain from the sale). This eliminates any tax liability from the sale of stock and prevents double-taxation.

Now, read on to make sure this simple approach applies to your situation…in my experience, it usually does.

I find it helpful to classify employer stock plans as one of three types:

1) Incentive Stock Option (ISO) plans,

2)  Employee Stock Purchase Plans (ESPP) and

3) everything else.

ISO and ESPP plans have their own unique rules. Because these plans are far less common, I’m not going to address them here. Your employer should tell you if your plan is considered an ESPP or ISO plan. If so, stay tuned and I may get around to posting something on those. For now, I’m just going to address the “everything else” plans.

The way most employer stock plans work is as follows: You’re “granted” the right to “exercise” options to buy stock in a company once certain criteria are met. Often the criteria involve a certain amount of time with the company, sometimes they’re based on performance goals, usually you pay very little or nothing for the stock out of pocket. The point is when you’re initially “granted” the stock options, you generally do nothing from a tax standpoint. (Of course, you could make what’s called an 83(b) election which will change the tax treatment, but that’s fairly uncommon and beyond the scope of this article.)

However, once you meet the conditions necessary to “exercise” the stock option, and generally you must then make a decision to actually “exercise” the option and purchase the stock, your rights are considered to have “vested.” This means you now have full, unrestricted ownership of shares of the company stock which you may do with what you wish. And you also have income for tax purposes when this occurs…which is where things tend to get confusing.

The first thing to know is the “income” is the difference between what you pay out of pocket for the stock (often nothing), and the Fair Market Value of the stock on the exercise date. This amount is generally reported as wages to you by your company, and the amount will be included in your wages reported on your W2 at the end of the year. And anytime you have wages, your employer is required to withhold taxes on that amount, and this is where the confusion often originates.

The second thing to know about exercising employer stock options is how the withholding is handled. Normally when you get paid, your employer just withholds some of the money you’ve earned and pays it to the government to cover the tax liability generated by that income. But when your income is in the form of stocks, not cash, your employer can’t simply give the government some of the stock to pay the tax debt. Instead, your company must sell part of the stock you’re exercising and use the proceeds to pay the withholding tax. So even though you may just hold on to the stock you receive, you’ve still got a sale of stock that needs to be reported.

And that brings us to the third thing to know when exercising employer stock…how to report the stock sale. Since some of the stock you exercised was immediately sold, you’ll usually receive a 1099-B reporting the stock sale. And this is where it’s very common for people doing their own taxes (or occasionally people having their taxes done by an inexperienced preparer at one of the tax chain stores) to pay double-taxes on the income from exercising employer stock options. The “income” from the stock that was exercised and sold on the same day gets reported on both your W2 and a 1099-B, so how do you avoid paying tax twice on this amount since it’s reported twice? The answer lies in knowing your cost basis for the stock.

Cost basis is usually the amount you pay for stock, which is why some people mistakenly think they have no basis in the stock they exercised…resulting in double-taxation when they report the sale as 100% gain even though it’s already income on their W2.

In fact, cost basis also includes the amount of income recognized (and taxed) on your W2. Since the amount included on your W2 is the Fair Market Value (minus any out of pocket price you paid) of the stock on the exercise date, and the stock was sold on the exercise date, then the proceeds from the sale and the cost basis will almost always be exactly the same. Typically the only difference will be a small amount to cover broker fees, so you’ll actually have a slight loss when you report the sale. As a result, you have no gain, and therefore no taxable income, from the sale reported on 1099-B. Double-taxation avoided.

Reporting cost basis equal to proceeds, and therefore no gain, is quite simple really. So why do so many people get it wrong? Well, this is because most people use software, and software has to account for all the less common situations. If you know that your only stock sale is a same-day sale of exercised stock (and it’s not an ISO or ESPP), you can skip all the fancy guidance in whatever tax software you’re using. Just report the proceeds with a cost basis equal to proceeds and you’re done. That’s pretty simple…and it’s the most common situation.  (You might be able to add a little bit to your basis due to the transaction fees from the sale, but missing this will usually only result in a few extra dollars of tax liability, so it’s nothing to worry about.)

If  you sold some employer stock after holding it for awhile, then you’ll probably want to use the guidance offered by your tax software. However, it’s always a good idea to check the results at the end and look at the cost basis reported on Schedule D before you submit your return. The cost basis should almost always be at least equal to the Fair Market Value of the stock on the date you exercised it. This is easy to determine using any number of online tools that allow you to look up historical stock prices. And don’t forget to multiply the Fair Market Value of one share by the total number of shares sold!! I’ve seen a few returns where individuals following the guidance for their software reported their basis as the share price of a single share…even though they’d sold hundreds, or even thousands, of shares.

If the cost basis reported by your tax software differs significantly from what you think it should be by simply looking up the historical price on the exercise date, it’s time to have a professional review your work. There are many, many ways this could happen, and the explanations are anything but “simple.”

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Adjustments, Credits, and Deductions…what’s the difference and why it matters

March 19, 2015

Pop quiz: Given the choice between a $4000 deduction or a $2500 credit, which would you take?

If you don’t know the answer (and why), you might wind up making a very costly bad decision at tax time.

This post is inspired by a recent question a client asked me (details altered slightly to protect the innocent…):

I have stock I’ve held for many years that has appreciated about $100,000. I’m considering selling it because I’ve heard capital gains rates are at an all time low and may soon rise, plus I expect my own income to rise in coming years. I’ve heard the tax rate is 15%, which would be $15,000. I also may need a minor operation soon, which I’ve been told will probably also cost around $15,000. Can I just deduct the medical costs against the tax so I don’t pay any tax from selling the stock?

The first part of this question is actually very savvy. Indeed, long-term capital gains rates (the tax rate you pay on the gain from selling assets you’ve held more than a year) are the lowest they’ve been in nearly a century, and almost certainly will rise in the fairly near future. So selling now while capital gains rates are so low can be a good move in many cases. However, the actual question at the end demonstrates a very common and fundamental misunderstanding about tax credits and deductions.

This article attempts to clear up the confusion surrounding adjustments, credits, and deductions. These three words refer to similar concepts, and they all have the net effect of lowering your tax bill. However, they each lower your tax bill in slightly different way. So it can often be the case that $1 of one is worth more than $2 of another.

Tax credits are the best kind of tax reduction. A credit reduces your tax liability dollar for dollar in the amount of the credit. A popular new credit is the American Opportunity Credit. This credit reduces your tax liability dollar for dollar on up to $2,000 of qualified educational expenses. For example, if you have a $5,000 tax liability before considering education expenses, but then you include the $2,000 of qualified expenses on your return, you just reduced your tax liability to $3,000.

Most credits aren’t worth 100% of the expenses that qualify for the credit.  In fact, the American Opportunity Credit becomes a 25% credit on qualified expenses above $2,000 but less than $4,000. So if you had $3,000 in qualified expenses, you’d get a $2,250 credit — $2,000 plus $250 on the amount over $2,000 (25% of $1000 = $250).

The important thing to realize is that once you know the amount of a credit, you know that it will reduce your tax bill by that same amount.

(Most credits are limited by your total tax liability, meaning if you only have a $1000 tax liability, a credit of more than $1000 will still only reduce your bill to $0. But there are a few credits that are “refundable” and can result in negative tax liability where the IRS actually pays you money. For more info, see this bankrate.com explanation)

Deductions reduce your taxable income. While people most often ask “What can I deduct?” when looking for ways to reduce their tax bill, deductions are actually the least valuable form of tax reduction. There are two main reason for this.

First, deductions don’t reduce your tax directly, but only the amount of income that is used to calculate your tax. In other words, they only reduce your tax by a percentage of their value. And that percentage is determined by your marginal tax bracket. Most taxpayers fall into either the 10% or 15% tax brackets, meaning that’s the percent of tax they pay on each additional dollar earned. So a $1,000 deduction for a person in the 15% tax bracket is actually worth $150 in tax savings. For somebody in the 25% tax bracket, the next largest bracket, that $1,000 deduction would be worth $250.

Second, and more important, deductions offer no tax savings at all in many situations. Nearly everybody gets a “standard deduction” they can use to reduce their taxable income automatically (in 2014, this amount was $6,200 for Single filers, $12,400 if Married Filing Joint).  If your total deductions are less than the “standard” amount, you receive no benefit at all from them because you simply take the standard deduction (with a few rare and minor exceptions). Only when the total of your deductions exceeds the standard deduction do you benefit from “itemizing” your individual deductions and taking that value instead of the standard amount. For most people who don’t have a mortgage, this means they don’t benefit from these deductions–unless they have a lot of other deductions. Furthermore, many deductions are only allowed if they exceed a certain percent of your Adjusted Gross Income (AGI). For medical expenses, only expenses that exceed 7.5% of your AGI can be deducted. For work-related expenses, investment expenses, and most miscellaneous deductions, only expenses that exceed 2% of your AGI can be deducted. (Expenses in the 2% category can be added together before the 2% reduction, they don’t have to individually exceed 2% of AGI.)

As a result, many people who think they’re going to benefit from a substantial deduction receive no benefit at all, or the benefit is significantly less than they expected.

Adjustments are reductions in your Adjusted Gross Income. These are often referred to by accountants as “above the line” reductions. In this case, “the line” refers to your AGI–aka Line 37 on recent year 1040 Forms. Adjustments reduce your taxable income, much like deductions, but unlike deductions they are not subject to any limitations based on percentage of AGI. Plus you can still take the standard deduction and receive the benefit from adjustments. Because adjustments reduce your AGI, they have some additional benefits as well.

Your AGI determines a number of things. Most importantly, your AGI determines your eligibility for most tax credits and deductions. (And, paradoxically, your AGI can determine your eligibility for adjustments and income reductions–such as Social Security not being treated as taxable–even though these items affect your AGI. It sounds circular, but it’s accomplished through the use of Modified AGI which would require a separate article.) As a result, adjustments can not only reduce your taxable income, but increase other credits and deductions as well.

One relatively common example I’ve seen is reducing your AGI to benefit from the Saver’s Credit, a credit that can be worth 10%, 20%, or even 50% of any amount you contribute to qualified retirement accounts. This credit can be claimed by individuals with AGI below $26,500 and married filing joint couples with AGI below $53,000, so a fairly large number of taxpayers potentially qualify. If you’re just above one of the thresholds for this credit, a reduction in your AGI by, for example, taking an adjustment for qualified tuition and fees might result in a few hundred dollars in savings as a result of the Saver’s Credit now that your AGI is below the threshold–plus the savings from reducing your taxable income.

Adjustments are less restricted than deductions, and they can have added benefits by reducing your AGI. (In fact, in rare cases, I’ve seen adjustments result in tax savings larger than the actual amount of adjustment thanks to this domino effect.) Generally speaking, adjustments are more valuable than deductions and less valuable than credits.

Answer(s). So to answer the original pop-quiz question, which is better: $4000 deduction or $2500 credit? Because the top marginal tax rate is 35%, this means a $4000 deduction can’t be worth more than $1400 (=4000 x .35), and for most taxpayers who are in lower tax brackets, it would be worth even less. A $2500 credit, on the other hand, is worth $2500. So the choice is clear: the credit is better.

Notice I didn’t ask to compare to an adjustment, because due to the possible domino effect of reducing AGI, it’s impossible to say how much an adjustment will be worth without knowing many details about the tax return.

And regarding my client’s question about medical deductions, here are the two main considerations:

  1. Deductions reduce your taxable income, not your tax liability directly, so $15,000 in deductions won’t directly offset $15,000 in income tax. It can only reduce the income that is used to calculate that tax liability. (In other words, he was confusing deductions with credits.) And…
  2. …A $15,000 medical deduction still has to be reduced by 10% of AGI (which based on $100,000 in income from the stock sale must be at least $10,000). And if the remaining deductible expenses plus other itemized deductions don’t exceed the standard deduction, then there’s no tax benefit at all from the medical expenses.

After considering all the factors, I advised this particular client to avoid selling the stock and doing the surgery in the same year if practical, because the income recognized from the large stock sale would wipe out nearly all the benefit from the medical deduction. This turned out to be quite the opposite from his original assumption (do surgery in the same year to get big tax savings), and he was very glad he’d paid for the advice before making his decision.


Somebody claimed my dependent! Now what?

March 12, 2015

Every year thousands of taxpayers attempt to e-file their return, only to get a nasty surprise–somebody else claimed one of their dependents. In the IRS e-file system, once a taxpayer appears as a dependent on a tax return, no other return will be accepted with that same person also claimed as a dependent. Unfortunately, some unscrupulous individuals will rush out and claim a dependent, usually a child, that they aren’t legally allowed to claim on a return filed very early in the tax filing season. Most commonly, this occurs among separated parents when a non-custodial parent with no permission to claim a dependent does so anyway.

So what does the person legally entitled to claim the dependent do? Well, while the authorized parent will wind up getting the tax breaks they’re entitled to from the dependent, unfortunately it may take some time.

In order to claim a dependent that has already been “claimed” in the e-file system, a taxpayer will have to file a paper return by mail. With that return, the taxpayer may want to include a brief letter explaining the situation, and include an item of evidence that the taxpayer actually has the right to claim the dependent in question. For example, a parent could include a copy of the child’s report card mailed to the parent’s address as proof of being the custodial parent. Most likely (although I am not aware of any fixed policy on this), the IRS will process the refund for the taxpayer based on claiming the dependent in question. Several months later, both individuals who claimed the dependent will likely get letters from the IRS demanding proof that the child may legally be claimed by the taxpayer. The unauthorized parent, as determined by the evidence provided to the IRS, will have to pay back the difference in taxes resulting from the dependent, and significant penalties as well.

Unfortunately, paper filing means waiting longer to get a refund. For many parents, this money may be urgently needed, and the extra weeks (or possibly months) involved in processing a paper return can cause financial difficulties. In this situation, there is one strategy that may offer some help. If the authorized parent is getting a refund even without the child that has been improperly claimed, then one strategy is to e-file a return claiming all dependents, deductions, and credits except for the dependent who is already claimed. This will result in the taxpayer getting part of the refund very quickly. The remaining refund can then be claimed by filing an amended return that includes the dependent in dispute. Filing the amendment will lead to the same process described above; both taxpayers claiming the dependent will be contacted and asked for evidence of their position.

Unfortunately, this situation is so common that nearly all tax preparers have seen it at some point, often multiple times. But rest assured the IRS will make sure that only individuals legally authorized to claim dependents will actually get the tax benefits from doing so.


More common mistakes to avoid

March 5, 2015

Just a quick add-on to last week’s post, here are a few more quick tips to keep in mind during tax season…

  1. Don’t miss out on the Retirement Savings Contribution Credit (or Saver’s Credit). If you’re single and make less than about $30,000/yr, or married w/ a combined income of less than $60,000/yr, you may be eligible for this credit. If you contribute to an employer-based retirement plan, or to an individual retirement plan such as a Roth IRA or Traditional IRA, you can receive a tax credit for up to 50% of the amount you contribute to the account. It’s the IRS giving you money for giving yourself money. And if your employer does matching contributions, you can really leverage your contributions. More information available from the IRS.
  2. If you want to check the status of your refund after you’ve filed your return, go to the source: The IRS. You can use the “Where’s My Refund?” tool from the IRS to check on the status of your return after it’s been transmitted to them by your tax software or tax preparer. (Also available in Spanish.) This will be the most up-to-date information available about the status of your refund.
  3. Use the best filing status. It’s very common for newly married couples to want to file separately at first since they don’t feel like they’ve “merged” their finances. In nearly all cases, using the Separate filing status will result in a worse result. There are a few exceptions to that, but in general avoiding the Married Filing Separate status will save you a lot of money.

That’s all for this week. If I run across more common errors, I’ll post them here.