The IRS contacts thousands of taxpayers each year as a result of improperly reported employee stock transactions. For many financial advisors, employee stock is one of the most complicated areas of the tax code, largely because many clients who receive stock options understand very little about what they own. If your clients own employee stock, here’s what they should know.
Know What They Own
Does your client have ISOs, NQSOs, RSAs, RSUs or ESPPs? Each of these types of stock options has a different tax treatment and is reported differently. Before you start their tax return, make sure you have documentation from their employer with details about the options as well as any and all Form 1099-Bs from the broker.
What is their cost basis?
Their cost basis is the amount they paid for the stock, and it includes any dollar amount on which they have paid taxes. As an example, when an individual exercises a Nonqualfied Stock Option (NQSO), the bargain element (the difference between the grant price and the market price) is considered compensation income and is reported as income on their W-2, found in box 12 with the code “V.” This amount is included in their cost basis along with the amount paid for the stock.
It gets a little trickier with Employee Stock Purchase Plans (ESPP’s) because of the holding period requirements. And with Incentive Stock Options (ISO’s) your client will have one basis for regular tax purposes and another for Alternative Minimum Tax (AMT) purposes.
Qualifying or Nonqualifying?
In order to obtain favorable tax treatment for the sale of employee stock, your client must meet the holding requirements. The holding period depends on the type of stock held. In some cases, even if the holding requirements are met, there may still be income from the transactions that is taxed at the higher ordinary income rates. For example, there is generally a certain amount of income from ESPPs that is taxed as compensation income; the amount is determined by the holding period. NQSOs by their very nature are taxed at ordinary income rates at exercise, though their tax rate at the time of sale depends on the holding period.
What’s taxable?
When an individual exercises NQSOs, it is a taxable event. This is true whether they hold or sell the stock at the time of exercise. The second taxable event occurs at the time of the sale of the stock when there is a gain.
When a client exercises and holds ISOs, the fair market value of the stock less the exercise price is considered income by the IRS. Even though your client hasn’t received any cash at this point, the ISO exercise may result in an AMT tax liability. This is what’s known as “phantom income” on which your client would pay real tax. When they sell the stock in a later year, they may be able to recoup some of the taxes paid when they file their tax return and make an AMT adjustment.
Normally, there are no taxes due at grant, though for Restricted Stock Awards (RSAs) a special provision is available that allows the RSA holder to pay their taxes at grant. This is called the 83(b) election, and it is only available for Restricted Stock Awards.
ESPPs are taxed only upon sale, but at that point there is also an amount that is taxed as “ordinary” or “compensation” income, depending on the holding period. Sometimes an employee may have the option to pay the compensation income in the year of the exercise; when that is the case there should be good recordkeeping to ensure the taxes on this amount are not paid again at the time of sale.
What needs to be reported?
Even if your client does not have a reportable gain, the IRS will be looking to match up their tax return with the stock sale information it receives from the brokerage.