Exercising stock options is a good thing.

After all, most of the time, it means you’re becoming wealthier and being really, really smart about your long-term financial plan. ???? ????

But, like it or not, exercising stock options does add another layer of complications to your yearly tax filing… and if you’re not careful, can lead to double-taxation… and the dreaded IRS tax trap. ????

Fortunately, if you know what to look out for and which IRS forms to pay attention to, you can avoid it.

If you exercised stock options last year, you will receive a Form 1099B from the brokerage firm that handles your employee stock options. A new regulation issued by the Internal Revenue Service (IRS) requires the Form 1099B to show an “initial” cost basis for stock options exercised and sold last year.

This initial basis for Incentive Stock Options (ISO) and Nonqualified Stock Options (NQ) is the price paid for the stock, which is the exercise price (strike price), under your option grant.


How Not to Get Double Taxed

To avoid double tax, you must adjust the initial basis by adding any compensation included on your form W2 upon the exercise of the option. On the date of exercise, ordinary income is created for the difference between the strike price and the fair market value per share of your employer’s stock if you exercise a nonqualified stock option.

If you exercise an incentive stock option and do a same day sale, you will create ordinary income for the difference between your strike price and the fair market value per share. This income is reported on your form W2. If you do not adjust the basis on your tax return, then you will overstate your capital gains by the amount of stock option compensation included on your Form W2. In years prior to 2014, the form 1099B usually reported the correct tax basis which included the adjustment for any Form W2 income.


Example: Amanda Overstating Her Capital Gain (Don’t be like Amanda.)

For example, Amanda works for a tech company in San Francisco. She exercised 10,000 nonqualified stock options with a strike price of $11.25 and ordered a same day sale of those 10,000 shares when the stock was worth $43.50 per share. Amanda’s initial basis is: 10,000 Shares x $11.25 Strike Price = $112,500 Initial Basis Under the new regulation, $112,500 is what will be reported on form 1099B as the cost basis. Additionally, the difference between the selling price and the strike price of $32.25 ($43.50 minus $11.25) will be reported as taxable income on form W2.

Thus $322,500 (10,000 shares x $32.25) will be taxable income on Form W2. When Amanda reports her capital gain, her selling price is $435,000 (10,000 shares X $43.50). Her adjusted basis should be $435,000 which includes the initial basis of $112,500 plus the W2 income of $322,500.

Therefore, her correct capital gain is zero. If Amanda did not adjust her basis, she could overstate her capital gain by $322,500. ???? In that case, Amanda would pay both ordinary income and capital gain tax on the same money.


The News About Pre-2014 Shares Gets Worse…

Any shares you sold last year that were obtained from the exercise of stock options in a year before 2014 may show the adjusted basis.

If you have shares that were exercised and sold last year and shares that were sold last year but exercised in another year, your form 1099B may show the initial basis for some shares and the adjusted basis for others. Some shares will be reported right and others wrong. If this is you, it’s ok to pull your hair out now, but contact us before you do.

There will also be inconsistency in the cost basis reporting among brokerage firms. Due to differing interpretations of the new regulations, some brokerage firms may continue to report the adjusted basis rather than the initial basis for all employer stock options sold in 2014 or later years.


Three Tips to Avoid the Tax Trap

To avoid overpaying your income taxes, you should do the following.

  1. Carefully read your form 1099B, which should arrive by mid-February, including supplemental information to understand how the cost basis information was calculated.
  2. Make an adjustment on Form 8949, column g to correct your basis and assure you do not overstate your capital gain. Form 8949 is filed as part of your form 1040.
  3. Contact a tax preparer who specializes in stock options

If you sold shares acquired through an employee stock purchase plan (ESPP) you will also be impacted by this issue. If any ESPP income was reported on a form W2, you may need to make an adjustment to cost basis in the same manner as discussed above.


No Worries for Restricted Stock Units

Restricted stock units (RSU) are not affected by these new regulations. The cost basis reported on form 1099B for an RSU should be the fair market value per share at the date of vesting.


Make Sure You Avoid the IRS Tax Trap

We specialize in helping tech industry professionals with stock options. Avoiding the tax trap starts with a 15 minute initial call.

A 15 minute call is a lot better than an hour or more verifying the basis on form 1099B. You have better things to do. As part of our first meeting, after the call, we will review all your options with you and verify basis for any stock options sold so that verifying the accuracy of your 1099B is quick and easy.



We look forward to helping you on your path to a secure financial plan.
financial planning firm san francisco california