Sale of Nonqualified Stock Options
Nonqualified stock option (NSO) is an option that doesn’t qualify for the special tax treatment afforded incentive stock option (ISO). The tax treatment for NSOs is simpler and more straightforward. Here is an example:
XYZ Inc. grants its employee, Mike, NSOs to buy 100 shares of the company’s stock for $10 per share – the fair market value (FMV) on the grant date. The options vest over 5 years and must be exercised within 10 years. In year 5, the stock’s FMV has increased to $15 per share, and Mike exercises all of his options, buying shares worth $1,500 (100×$15) for $1,000 (100×$10).
Generally, there are no tax consequences when NSOs are granted. When you exercise an NSO, however, you must report compensation in income equal to the spread between the exercise price and the FMV on the exercise date. Going back to the example, Mike would receive $500 in compensation when he exercises his options. This $500 is taxable ordinary income and deductible by his employer. It’s included in wages on his W-2 and is subject to payroll taxes. In the case of a nonemployee, this amount would be reflected on Form 1099-Misc.
The problem is when you sell stock your broker sends you a Form 1099-B and files it with the IRS. The form reports your proceeds and maybe your basis. But when a 1099-B relates to stock acquired through the exercises of NSOs, the basis amount is probably wrong.
The 1099-B instructions state, “If the securities were acquired through the exercise of a compensatory option, the basis hasn’t been adjusted to include any amount related to the option that was reported to you on a Form W-2“. But this may or may not be true.
Until recently, brokers were permitted but not required to adjust basis to reflect the amount of compensation income reported when options were exercised, which means the $500 compensation in the example may or may not be added to the basis on Mike’s 1099-B. If the basis is not adjusted to include the $500, Mike will overpay his taxes.
If you sell stock acquired through the exercises of NSOs, don’t rely on the basis on your 1099-B. If your basis on the 1099-B wasn’t adjusted, you will overstate your gain or understate your loss which results the overpayment of your taxes. Determine the basis yourself and keep a record. If the basis on your 1099-B is wrong, correct it in your tax return.
Tax Tip: Reporting Capital Gains
It is easier than it used to be to report capital gains. Until recently, investors had to report the details about capital gains or capital losses on Form 8949. There was a lot of work for traders. In 2013, the IRS changed the rule.
Under current rules, Form 8949 is not required for a transaction if 1) you received a Form 1099-B from your broker showing that the basis was reported to the IRS (without any adjustment in box 1g) and 2) you don’t need to make adjustments to the basis or type of gain or loss reported on Form 1099-B. For these transactions, you may aggregate gains and losses, and enter the totals on Schedule D.
XYZ Inc. grants its employee, Mike, NSOs to buy 100 shares of the company’s stock for $10 per share – the fair market value (FMV) on the grant date. The options vest over 5 years and must be exercised within 10 years. In year 5, the stock’s FMV has increased to $15 per share, and Mike exercises all of his options, buying shares worth $1,500 (100×$15) for $1,000 (100×$10).
Generally, there are no tax consequences when NSOs are granted. When you exercise an NSO, however, you must report compensation in income equal to the spread between the exercise price and the FMV on the exercise date. Going back to the example, Mike would receive $500 in compensation when he exercises his options. This $500 is taxable ordinary income and deductible by his employer. It’s included in wages on his W-2 and is subject to payroll taxes. In the case of a nonemployee, this amount would be reflected on Form 1099-Misc.
The problem is when you sell stock your broker sends you a Form 1099-B and files it with the IRS. The form reports your proceeds and maybe your basis. But when a 1099-B relates to stock acquired through the exercises of NSOs, the basis amount is probably wrong.
The 1099-B instructions state, “If the securities were acquired through the exercise of a compensatory option, the basis hasn’t been adjusted to include any amount related to the option that was reported to you on a Form W-2“. But this may or may not be true.
Until recently, brokers were permitted but not required to adjust basis to reflect the amount of compensation income reported when options were exercised, which means the $500 compensation in the example may or may not be added to the basis on Mike’s 1099-B. If the basis is not adjusted to include the $500, Mike will overpay his taxes.
If you sell stock acquired through the exercises of NSOs, don’t rely on the basis on your 1099-B. If your basis on the 1099-B wasn’t adjusted, you will overstate your gain or understate your loss which results the overpayment of your taxes. Determine the basis yourself and keep a record. If the basis on your 1099-B is wrong, correct it in your tax return.
Tax Tip: Reporting Capital Gains
It is easier than it used to be to report capital gains. Until recently, investors had to report the details about capital gains or capital losses on Form 8949. There was a lot of work for traders. In 2013, the IRS changed the rule.
Under current rules, Form 8949 is not required for a transaction if 1) you received a Form 1099-B from your broker showing that the basis was reported to the IRS (without any adjustment in box 1g) and 2) you don’t need to make adjustments to the basis or type of gain or loss reported on Form 1099-B. For these transactions, you may aggregate gains and losses, and enter the totals on Schedule D.