Keeping it simple, cost basis is the original price you pay for an asset. It’s used as a starting point to calculate how much you earn on an asset, so the IRS knows how much to charge you for capital gains tax.
Sounds pretty simple, right?
In theory, yes.
But in practice…. not so much. ????
Truth is, it can get pretty complicated, pretty fast… especially when it comes to stock options.
As your stock options vest over time, each batch that vests into your possession (in the case of RSU) will have their own cost basis, depending on market value… even though you didn’t technically spend anything to gain that investment.
Ditto for each set of ISO you exercise: you’ll have your cost basis for how much you paid for each share, and then there may be another one to track for the alternative minimum tax.
Where Cost Basis Matters
When it comes to understanding cost basis for the purpose of managing your stock options, knowing & keeping track of your it is crucial.
In this guide, I’m going to show you where cost basis matters with different types of stock options, and also show you how to keep track of cost basis for tax purposes. (No one wants to get a scary letter from the IRS, after all.)
I’ll also give you some links for continued reading so you can go deeper, and be able to have an intelligent, productive conversation with your financial advisor.
Still looking for a financial advisor? Set up a call with one of us to see if a member of our team would be a good fit to help you.
Cost Basis with RSU
When your RSU vest into your possession, they’re shares of the company that you automatically own. No need to purchase them: they’re just a compensation benefit of working for your company.
If you define cost basis as the price of initial purchase (a common definition), then it sounds like RSU don’t have one – or has a cost basis of $0.00, right?
Wrong.
Because they’re given as compensation, they are “income,” and the IRS wants their share of what you earn with them too… even though they’re shares and not cash received through a paycheck.
So… you need to know their cost basis.
For RSU, the cost basis is the market price of each share on the day they vest. Simple, straightforward. This amount is what you are taxed on when the RSU vests and the shares release.
However, we all know share price doesn’t always stay the same: sometimes it goes up, and sometimes it goes down. (So, for your vested RSU, that’s either a capital gain or a capital loss when you decide to sell those shares.)
This is the second time when you need the RSU cost basis for taxes: in figuring out how much more you owe in capital gains after selling your shares for a profit, or how much of a loss you can report after selling them for less than the price they vested at.
Read more on this topic:
- Cost Basis and RSU: THE Easy-to-Understand Tech Employee’s Guide
- IPO & RSU: When to Sell Based on Share Price
Cost Basis with ISO
Cost basis for ISO is another place where it seems simple… but it gets complicated fast once you peel back the layers.
For starters, cost basis for ISO is based on the simple definition: it’s how much YOU pay for the shares, regardless of their market value. If your company offers you a buy-in price (or strike price) of $2 per share and you buy 500 shares, that’s a $1,000 cost basis.
But what if the market value of the shares was $20?
THAT, my friend, is where things get complex.
If you pay the AMT on the exercise of your ISO, you’ve got to also calculate the AMT (alternative minimum tax) cost basis, which uses the full market value. (In this case, 500 x $20 = $10,000.)
Read more on this topic:
Why & How to Keep Track of Cost Basis
If you miscalculate or keep track of the wrong cost basis, you could be in huge tax trouble: either you’ll over-pay way too much, and the IRS won’t bother telling you that you paid too much ????… Or, you won’t pay enough, and you will get a letter from the IRS demanding more ????…
Before 2011, it was actually up to you to self-report your cost basis to the IRS. But now, with more regulations in place, the brokerage firms and companies managing the buying & selling of stock are the ones who report it to the IRS.
That doesn’t mean it’s all automatically taken care of for you: Just like any system in the world, these firms have made errors, and from time to time, we’ve had clients whose cost bases are actually missing, which is no good.
If you don’t know your cost basis, you can get taxed for total gains without calculating your initial cost (which gets subtracted from your total gains), and be charged a lot more money.
To keep track, you need to have a solid method of keeping records. Fortunately, technology makes this really easy. All you need is a simple spreadsheet with the following columns:
- Date
- Share name (the company’s stock symbol)
- Market value
- Share type (RSU or ISO)
- Strike price (if applicable)
- Taxable amount on exercise/vest date
- Date sold
- Price sold at
- Total Gain/Loss
This will give you all the information you need to figure out the different types of cost basis: like when you need to calculate it for AMT.
Every time you acquire shares, vest RSU, exercise ISO, or sell any shares, update the spreadsheet.
You can even get really fancy and automate recording this data through different tech tools, but that’s another how-to tutorial for another time. (Or something you can talk to your financial advisor about.)
Read more on this topic:
Tax Preparation
Ultimately, cost basis exists for the entire purpose of figuring out taxes.
I’ve already mentioned taxes earlier, but I want to lay it out plain & simple for you right here, so you can have a bullet-point guide to help you understand what’s going on in your tax calculations.
First, we’ll start with RSU:
- RSU don’t have a purchase amount cost basis, because you do not pay for them. Instead, their cost basis is calculated by the market value of the shares on the day they vest.
- Any time RSUs vest into your possession (usually after the IPO), you’ll owe income tax immediately on the market value of the shares for the day they vested. (Even if the value goes down before you’re able to sell. I know, unfair. But I go into that more in this article.)
And now, for ISO:
- Any time new options vest, they are not taxed. The “vesting” of options just means you have more options you can exercise.
- Taxation of ISO happens at exercise for AMT, and when you sell for regular tax.
- Once you exercise, you may be taxed at the AMT rate for the difference between the market value and the strike price. (If the market value is $10 per share and you pay $2 per share, you add $8 per share to your taxable “income.”)
- If you wait 12 months or more before selling the shares you bought through ISO, those gains will qualify for long-term capital gains tax, which is lower than the ordinary income tax rate.
- Depending on your income, you’ll only be able to exercise a certain amount of ISO before you have to pay the AMT (alternative minimum tax). Work with your financial advisor to figure out how much this is for you.
Read more on this topic:
- ISO and AMT Under the New Tax Plan
- Incentive Stock Options, AMT, and Cost Basis: What You Need to Know
- How to Prepare for a Cash Acquisition & its Tax Implications
- Preparing for Taxes: A Checklist
- RSU, Capital Losses, and Wash Sale
Conclusion: Record Keeping is Your Best Friend with Cost Basis
By definition, cost basis is a fairly simple thing.
But once you start adding IRS rules and regulations to it… and when you realize it applies to thousands of dollars you earn and possibly invest in one year; it’s clear that even a tiny mistake in calculating it could cost you a lot of money. This is why record-keeping is so important.
While you can sit down with a calculator and handbook of IRS definitions to figure out your taxes for yourself, it’s almost always safer and a better value for your money to work with a financial advisor on this.
Not only will they make sure every single part of cost basis is correctly accounted for & that you have impeccable records, but they’ll also be able to pre-emptively do important tax math for you so you don’t accidentally trigger the AMT in a year when you can’t afford to pay it, for example.
