Form 1099-B: The basis is probably wrong for employees who exercised nonqualified stock options
Most of the time, employees will need to adjust their reported basis to avoid being taxed twice
Editor’s note: This article has been reviewed for changes following the passage of the 2017 Tax Cuts and Jobs Act. The information provided in this article was not affected by the 2017 TCJA.
A word to the wise for tax advisors and taxpayers when it comes to Form 1099-B, Proceeds from Broker and Barter Exchange Transactions: If you’re not adjusting the basis of stock acquired by exercising nonqualified stock options, you probably should be.
The basis reported on Form 1099-B for nonqualified stock options is most likely wrong
Why? Because, by law, stock brokers can’t include compensation reported on an employee’s Form W-2, Wage and Tax Statement, in the stock’s basis when preparing the Form 1099-B.
In the original proposed basis-reporting requirements, the IRS allowed brokers to adjust basis. However, after consideration of broker comments on the potential complications of determining and adjusting basis, the IRS ultimately decided that the system would be unworkable.
As a result, employees who exercise nonqualified stock options (sometimes called nonstatutory stock options) are often taxed twice on the income – once as compensation and again as capital gain on their individual income tax returns.
That is, unless the employee or his or her tax advisor adjusts the basis on Form 8949, Sales and other Dispositions of Capital Assets.
How tax reporting works for nonqualified stock options
Employees who gain equity in their company through a stock award plan commonly receive nonqualified stock options. There are various types of nonqualified stock options and an election that can affect the timing and amount of compensation an employee recognizes, but the basis in the stock acquired is generally the amount paid for it plus any amount included in compensation.
Nonqualified stock options involve two distinct transactions:
- Exercising the option to buy shares
- Selling the shares
Often, the two transactions happen at the same time, as though it were a single event (as in a cashless exercise). But for tax purposes, both transactions must be separately reported.
Tax reporting for the exercise of the nonqualified stock options is usually correct on Form W-2
Usually, tax reporting for the exercise of the nonqualified stock options is accurate. For example, if the amount to be paid per share (strike price) was $15 per share, and the price on the exercise date (exercise price) was $20 per share, the employee gained $5 per share. The employee’s W-2 would include that total amount in compensation.
Tax reporting for sale of the shares is usually incorrect on Form 1099-B
On the other hand, tax reporting for the sale of the shares usually isn’t correct. When the employee sells his or her shares, the basis in the shares is subtracted from the sale proceeds to determine the gain or loss reported on Form 1040, Schedule D, Capital Gains and Losses, and Form 8949.
With nonqualified stock options, the employee’s basis is the exercise price. The exercise price is the strike price plus the compensation that appears on the W-2. However, the broker can’t include this W-2 income as part of the basis on Form 1099-B. Form 1099-B can report only the strike price.
So, unless the taxpayer adjusts the basis reported on Form 1099-B to add in the compensation component, that amount will be taxed twice, first as ordinary income and again as capital gain.
To avoid double taxation, the employee or his or her advisor must make an adjustment on Form 8949.
Here’s an example
An employee is granted 1,000 nonqualified stock options to acquire the employer’s stock at a strike price of $10 per share. When the current fair market value of the stock is at $30 per share, the employee exercises the stock options. The bargain element of $20,000 [1,000 shares x ($30 exercise price - $10 strike price)] is ordinary income included on the W-2 as compensation. Since the exercise price of the option was $30,000, that amount is the cost basis when the shares are sold.
If the employee immediately sells the shares after the exercise for $30 per share, the broker would issue a 1099-B for the sale with a cost basis of $10,000, what the employee paid for the stock. The capital gain reported on the Form 1099-B would be $20,000 ($30,000 proceeds - $10,000 cost). To avoid paying tax on that $20,000 twice (it’s already been taxed as compensation), the employee must manually adjust the cost basis to $30,000 on Form 8949.
Alternatively, suppose the employee exercised the option in 2015, when the fair market value was $30 per share, but held the stock and sold it for $40 per share in 2016.
In this case, $20,000 would be added to the employee’s 2015 W-2, but the employee wouldn’t get a Form 1099-B until 2016. The Form 1099-B would report $10,000 of cost basis and $40,000 in sales proceeds. Again, to avoid double taxation on the $20,000, the employee must make an adjustment on Form 8949 to increase the cost basis to $30,000. The remaining $10,000 will be taxed as a capital gain.
Note: Restricted stock has a different reporting issue
There is a similar reporting issue with restricted stock (a type of nonqualified stock option), but it involves a different basis-reporting method. Employees generally pay nothing for restricted stock. When it vests, the fair market value on the vesting date is treated as compensation and reported on employees’ Forms W-2.
For example, an employee receives restricted stock worth $1,000 when it vests and $1,500 when the employee sells it. The $1,000 is treated as compensation and added to the employee’s W-2. When the employee sells the stock, the broker sends a Form 1099-B showing sales proceeds of $1,500.
Because restricted stock and restricted stock units are considered noncovered securities, Form 1099-B doesn’t report any cost basis. When cost basis is not reported on Form 1099-B, report the correct cost basis in column (e) of Form 8949. Thus, no adjustment is required in column (g).
Employees should get documentation
To ensure accurate reporting of nonqualified stock option cost basis, employees should get copies of stock option exercise confirmations from their employers and prior-year Forms W-2 showing compensation reported. Then, employees and their tax advisors can properly report cost basis and avoid getting taxed twice.
When cost basis is reported incorrectly on Form 1099-B, here’s how to adjust the basis.