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.”