Understanding the Cost Basis of Equity Award Shares
March 30, 2021
The IRS has extended the deadline for individuals to file their taxes until May 17. That gives you a little more time to help employees understand the cost basis of shares they’ve acquired under your stock plan.
What Is the Cost Basis of Stock?
When US taxpayers sell capital assets, like stock, they pay tax on any profit realized on the sale. The cost basis in the stock is used to determine a taxpayer’s profit: at a minimum, it includes the amount the taxpayer paid to acquire the stock. In the case of shares acquired pursuant to equity awards, the cost basis also includes any income the employee has already paid tax on in connection with either the acquisition or the sale.
Taxpayers subtract their cost basis from their net sales proceeds to determine their taxable capital gain. If their cost basis is greater than their net sales proceeds, they’ll report a capital loss, which can reduce their tax liability in the year of the sale.
A Simple Formula
For stock acquired under compensatory arrangements, the cost basis can be determined using the following formula:
* This includes any compensation income recognized in connection with either the acquisition of the stock (in the case of nonqualified arrangements) or the sale of the stock (in the case of tax-qualified arrangements).
Form 1099-B Complicates Matters
That formula seems straightforward, but it can be quite confusing for employees (and even tax advisors). According to myStockOptions.com, failing to properly report their cost basis is a very common mistake employees make when reporting sales of stock they acquired through their company’s stock plans (12 Tax-Return Mistakes to Avoid with Stock Options and ESPPs).
This is further complicated by the IRS reporting requirements for Form 1099-B. In most cases, brokers are required to issue a Form 1099-B for sales of stock that they facilitate. This form has important information for the seller, including the net sales price and the seller’s cost basis in the stock.
For shares that were acquired through stock compensation programs, the cost basis reported on Form 1099-B will often either be incorrect or will be omitted. This is because the IRS prohibits brokers from including the compensation income recognized by the employee in the cost basis reported on Form 1099-B. In addition, the IRS only requires brokers to report a cost basis if cash is paid for stock, so shares that employees receive for free under restricted stock and unit awards often won’t have a cost basis reported on Form 1099-B.
The following table shows the cost basis that is likely to be reported on Form 1099-B and the employee’s actual cost basis:
|Transaction||Cost Basis Reported on Form 1099-B||Actual Cost Basis|
|Sales of shares acquired pursuant to NQSO exercise||Exercise price||FMV at exercise|
|Sale of shares acquired pursuant to RSU award||Not covered, practices vary*||FMV at payout|
|Sale of shares acquired pursuant to restricted stock award||Not covered, practices vary*||FMV at vest (or grant, if 83(b) election filed)|
|Disqualifying disposition of shares acquired pursuant to ISO exercise||Exercise price||Lower of FMV at exercise or sale price|
|Qualifying disposition of shares acquired pursuant to ISO exercise||Exercise price||Exercise price|
|Disqualifying disposition of shares acquired pursuant to ESPP||Purchase price||FMV at purchase|
|Qualifying disposition of shares acquired pursuant to ESPP (gain realized on sale)||Purchase price||Purchase price plus compensation income recognized on disposition|
|Qualifying disposition of shares acquired pursuant to ESPP (loss realized on sale)||Purchase price||Purchase price|
* Because employees don’t pay for shares acquired under restricted stock and unit awards, these shares are not covered by the IRS’s regulations governing cost-basis reporting. The cost basis may be omitted from Form 1099-B altogether or may be reported as $0. Some brokers might report the FMV of the stock at the time the award was subject to ordinary income taxation as the cost basis (this is the correct basis).
What Do Employees Need to Do to Correct Their Cost Basis?
Employees don’t correct their cost basis. Instead, if the Form 1099-B reporting their sale includes an incorrect basis, employees should report that same basis on their tax return. Then they’ll report an adjustment that reduces their taxable capital gain (or increases their capital loss) on Form 8949.
Why Is This Important?
As you can see, for the common (and not so common) transactions described in the table above, there are only a few where the cost basis reported on Form 1099-B is correct. In all other cases, the cost basis reported on Form 1099-B is too low. If employees don’t understand this, they are likely to over report their capital gain on the sale and pay tax on the same income twice. If the capital gain is short-term, almost doubles the taxes they pay on the transaction!
You might be tempted to think that this doesn’t concern you; after all, it’s on employees to understand how to report their sales on their tax return. But when employees inadvertently pay a significant portion of their plan earnings to Uncle Sam, it can ultimately reflect back on the company.
The purpose of your equity program is to compensate employees and create wealth for them, not to compensate the US government. If employees pay over the lion’s share of their gains to the IRS, your stock plan isn’t accomplishing its objective.
Not only that, if employees feel like most of their earnings in the stock program go to pay taxes, they will not view the stock program as valuable. This can cause the program to become a disincentive.
And finally, if employees are confused and frustrated by the tax consequences of their stock plan transactions, this can also de-incentivize employees. Your stock plan can only accomplish its objectives of motivating and retaining employees if employees are excited about participating in the program.
Three Things You Can Do to Help Employees
Here are three things you can do to help your employees understand how to report sales of shares acquired under your stock programs on their tax return.
- Make sure employees know that they need to report their sales on Form 8949.
- Warn employees that the cost basis on their Form 1099-B may be incorrect and help them understand how to ensure they pay the right amount of tax on their sales.
- Find out how your designated broker reports sales on Form 1099-B and communicate this to employees. While the IRS rules I describe above are fairly clear, there is a lot of variation in practice among brokers. Providing clarity to your employees is one of the most helpful things you can do for them.
The NASPP offers a wealth of resources to help you create your own employee communication materials, including the following:
- Cost Basis Cheat Sheets
- Sample FAQ with Annotated Form 8949
- Sample Email: Five Things You Need to Know About Form 1099-B
Pro Tip: Our resources are designed to address a wide variety of scenarios. Do your employees a big favor by removing all the noise that doesn’t apply to them. For example, if you don’t allow early exercise, remove the instructions about those transactions.