We see it all the time. You receive tax documents from your employer (W-2) and from your stock account custodian (1099 from Fidelity, Charles Schwab, Etrade, etc.). You report what’s on the forms directly into TurboTax, H&R Block, or some other over-the-counter tax software. Ouch! I owe a lot of tax! You then proceed to lose sleep for the next several weeks, and finally submit those returns on April 15.
Even better, you hire a qualified tax professional to make sure your tax returns are prepared correctly and hope that any deductions you are entitled to are properly captured. Wow! I still owe a lot of tax! Often Accountants say, after doing a quick Google search of “how do taxes work on ISO’s?”, “Well, you made a lot of money. You sold stock options and have to pay tax on that sale. You should have held the options for 1 year from exercise and 2 years from grant”. You shrug and yearn for better results next year.
The problem is simple, tax forms are often incorrect. If you exercise and sell ISO’s in the same tax year, your employer is required to report the gain on your W-2 as ordinary income. Depending upon who your company uses for payroll, it may not be clear what this or how to report it.
To add insult to injury, often times the custodians of the world (Fidelity, Schwab etc.) send you a 1099 that shows your option price and the sales price; this totally disregards the fact that the gain has now been reported on your W-2! Simply, if you trust the tax forms, you’ve double paid the tax.
Here is an example:
You have Incentive Stock Options (ISO’s) with a strike price of $1 which you were granted 2 years ago, and they are fully vested. Let’s say you have 10,000 shares vested. The current private or public stock price is $5 per share.
In February you decide to exercise the options (convert them to stock/shares) and cut a check to your plan administrator for $10,000 (10,000 options at $1/share). In May, the stock price is now $10/share due to some recent publicity about your Company and you feel it is a great time to sell. So you sell and put $100,000 in your bank account. (10,000 shares at $10/share).
In February of the next year, you receive your W-2 and your 1099 showing the sale. The W-2 has 50 different numbers on it and you input everything directly. The 1099 shows your basis of $10,000 (exercise price), and the proceeds of $100,000 from the sale. You agree with that so you report the gain of $90,000 ($100,000 – $10,000) as a short-term gain on your Schedule D.
What you failed to realize is that your W-2 has a little number added in on one line of it called summary of “other income”, which is $40,000. This is, in fact, the difference between the exercise price and stock price when you originally exercised your options (10,000 shares at $5 – $10,000 you paid to exercise them). It has been included as a disqualifying disposition in your W-2 by your employer, and you have now paid tax twice on $40,000 of income.
It would be appropriate to adjust your basis to $50,000 when reporting the sale on Schedule D to properly report a short-term gain on $50,000. After all, you already paid taxes on the first $50,000, so now you need to pay taxes only on the second $50,000.
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