If you participate in an Incentive Stock Option (ISO), Employee Stock Purchase Plan (ESPP), or have Restricted Stock Units (RSUs), there’s a significant chance you may have overpaid on your taxes. From my experience reviewing tax returns, many that involve ISOs, ESPPs, or RSUs were not correctly filed.

This is crucial information if you hold ISOs, ESPPs, or RSUs, especially since the IRS made significant changes to how the cost basis is reported on your Form 1099-B. This change took effect on January 1, 2014. It’s essential to make the necessary adjustments to avoid double taxation.

To clarify these issues, let’s define some terms commonly used in this discussion.

Statutory and non-statutory plans represent two principal categories of equity awards granted to employees.

Statutory Plans: These comply with IRS criteria to qualify for special tax treatment. Non-Statutory Plans: Also known as “non-qualified stock options” (NSOs or NQSOs), these do not meet the IRS criteria for special tax treatment and are subject to different tax regulations.

ISOs are an example of statutory plans. RSUs, however, are non-statutory plans. ESPPs can be offered under either plan.

When you sell stocks under statutory plans, the sale can be classified as either a qualifying disposition or a disqualifying disposition, based on the holding period:

  • Qualifying Disposition:
    • If sale_date - exercise_date > 1 year AND
    • sale_date - grant_date > 2 years
  • Disqualifying Disposition:
    • If the above conditions are not met.

The terms “long term” and “short term” capital gains retain their standard definitions.

  • Long Term Capital Gain:
    • If the holding period > 1 year, taxed at a reduced rate.
  • Short Term Capital Gain:
    • If the holding period ≤ 1 year, taxed as ordinary income at the marginal rate.

It’s possible to have a disqualifying disposition yet still qualify for long term capital gains.

  • Ordinary Income: Income that is subject to income tax but not to FICA taxes (Social Security and Medicare taxes). Examples include bank interest and capital gains.
  • Compensation: Income that is subject to both income tax and FICA taxes. An example of this would be your wages.
  • Grant or offer: The employer’s promise to grant you stock options.
  • Vest or Exercise: The point at which the stock options or RSUs become yours.

Let us discuss some common forms of equity awards.

ISO

Only pay tax when sold.

  • Qualifying disposition: Taxes are levied only on the long-term capital gain (or loss), which is the difference between the sale price and the option purchase price, and not as compensation.

  • Disqualifying disposition: You pay ordinary income tax on the “bargain element”, the spread betwen market price and purchase price, but only up to the actual gain realized if the stock is sold for more than the option purchase price.

Example 1:

  • Market price at exercise: $100
  • Sale price: $90
  • Option purchase price: $70

The ordinary income (Box 1 of W-2) is $20 ($90 - $70, up to the gain), and the capital gain is $0 (not to pay tax twice).

Example 2:

  • Sale price: $120
  • Market price at exercise: $100
  • Option purchase price: $70

The ordinary income (Box 1 of W-2) is $30 ($100 - $70), and the capital gain (long or short depending on holding period) on $20 ($120 - $100).

For both situations, the broker will report the option purchase price ($70) as cost basis, you need to increase the cost basis to reflect the ordinary income realized, or you end up paying tax twice.

ESPP

Same as ISO, you pay tax only when the stocks are sold for ESPP offered under a statutory plan.

A qualifying disposition occurs when:

  • The sale happens at least two years after the grant date, and
  • More than one year after the purchase date

Tax Treatment in a Qualifying Disposition

  • Ordinary income = the lesser of:
    1. The discount based on FMV at grant:
        FMV at grant – purchase price (based on FMV at grant)
    2. The actual gain on sale:
       Sale price – actual purchase price
  • Capital gain = any remaining gain after adjusting for ordinary income.

Example 3:

  • FMV (Fair Market Value) at grant = 100
  • Exercise price as if on grant date = 85
  • FMV at exercise = 200
  • Exercise price = 170
  • Sale price: 250

Ordinary income is min(100-85, 250-170) = 15, and the capital gain is 250-(170+15) = 65.

The broker will report that you have a 80 gain (250 - 170), you should increase your basis by 15 to derive 65 gain because the 15 has been reported as regular income on your W-2.

  • Disqualifying disposition must realize ordinary income of bargain element (FMV at exercise minus purchase price) at year of sale even there is a loss. The cost basis is the purchase price plus the bargain element, ie, the FMV value.

Example 4:

  • FMV at exercise = 100
  • Sale price: 90
  • Purchase price: 85

The ordinary income: 100 - 85 = 15, and the capital gain: 90 - 100 = -10.

The broker will report that you have a $5 gain ($90 - $85), you should adjust your basis to reflect a $10 loss because the $15 has been reported as regular income on your W-2.

Notes:

  • Some companies include a look-back provision in their ESPP, allowing the purchase price to be based on the lower of the fair market value (FMV) at the grant date or the purchase date. This can result in the actual purchase price being more than 15% below the FMV at the time of purchase, even though the maximum discount allowed by IRS rules under a qualified plan is still 15%.
  • A qualifying disposition often results in lower ordinary income, as shown in Example 3. However, if the stock price declines between the grant date and the purchase date, then in a disqualifying disposition, the ordinary income may actually be lower than in a qualifying disposition. In general, lower ordinary income is favorable, since it is taxed at a higher rate than long-term capital gains.

Most people forget the ordinary income in above formula in computing capital gain, they pay tax on Ordinary income twice, once as ordinary income and once as capital gain.

RSU

RSU is non-statuary stock option. You do not pay tax when the stock was granted, but you pay taxes when the stock was transferred to you before you sell it. You pay tax on the benefit you get (market price minus the purchase price) as compensation.

You can either transfer external money to pay for the taxes, but by default they will sell some stocks to cover the tax. If you do not sell enough stock to cover the taxes, and later the stock becomes worthless, you may not have enough money to cover the taxes.

Example:

  • Number of shares: 10
  • Purchase price: $0
  • Share price: $1,000

$10,000 ($1,000 * 10) will be taxed as ordinary income. Suppose 40% of tax needs to be paid, then you need either to come up with $4,000 to pay taxes from your pocket, you sell 4 shares to cover the taxes ($1,000 * 4).

If you sell 4 shares to cover the taxes, then on your brokerage form, it will show that you have a $4,000 capital again because the purchase price is $0. However because the benefit of having the stock for free has been added to your W-2 and taxed as compensation, then you should increase your basis to $4,000 to derive a $0 gain. Because of cost of sale, you should have a small loss. If you do not do this, then you will pay taxes twice, once as compensation, and once as capital gain.

Suppose after many years, you want to sell the rest of 6 shares and you forgot that you have paid taxes already up to $1,000 per share and the company does not provide you with the proper paperwork, you will end up paying taxes again.

Documents needed for the cost basis adjustment:

  • Form 3921 from employer if you have ISO or RSU.
  • Form 3922 from employer if you have sold stocks from ESPP.

Those are official forms, but I have seen supplemental document from brokers to help you make adjustment for the cost basis.