Tax Center: ISOs: W-2s & Tax Returns

By the middle of February, you should have received your IRS Form W-2, as well as a statement from your stockbroker if you sold any stock last year. Puzzled by your W-2 or a 1099-B form? Don't quite know how and where to report sales of company stock on Schedule D? Even if you hire someone to do your taxes (tax specialists are helpful), you can nevertheless benefit by knowing some of the basics about income tax reporting for company stock.

• Mistake No. 1: Double-counting income
• Mistake No. 2: Failure to report sales; cost basis errors
• Mistake No. 3: Fouling up AMT calculation
• Mistake No. 4: AMT credit
• Mistake No. 5: Overpaying AMT in year of ISO sale
• Mistake No. 6: Failing to track stock splits
• Mistake No. 7: Miscalculating taxes due from ESPPs
• Mistake No. 8: Not writing off worthless securities
• Mistake No. 9: Failing to use special IRS sections
• Mistake No. 10: Math and loss carry-forwards
• Mistake No. 11: Mechanical errors
• Additional points, including tax credits and extensions

If you need to report income from restricted stock or restricted stock units, see a companion article.

Tax-Reporting Errors To Avoid

Here are tips for sidestepping common pitfalls (see also the FAQs on mistakes involving stock options and ESPPs).

Mistake No. 1: Double-Counting Option Income

When you exercise NQSOs, even if you don't sell any shares, the difference between the exercise price and the fair market value (FMV) of those shares will be treated as ordinary income and included in Box 1 of your Form W-2 and in the other boxes for state and local income (see the FAQ with the relevant annotated diagram of Form W-2). For ISOs, only when you make a disqualifying disposition will the income appear on your W-2 (see the FAQ with the relevant annotated diagram of Form W-2).

Companies also specify NQSO income by putting it in Box 12 of your W-2, with Code V, which became mandatory starting with your 2003 W-2 (does not apply to ISOs or ESPPs). When you fill in the line for "Other income" on your Form 1040 (Line 21 of the 2009 form), don't make the mistake of listing the amount shown in Box 12 of your W-2 or any income already included in Box 1 for stock compensation. That would be double counting.

To double-check how much compensation came from salary versus options, "compare your year-end pay stub with your W-2," advises CPA Glenn Sweeney, head of SFM LLC, a financial advisory firm in Manchester, NH. The difference between the two statements should reveal your option income.

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Mistake No. 2: Failing To Report Sales Or Identify Your Cost Basis

If you exercised NQSOs last year, the withheld federal, state, Social Security, and Medicare taxes will appear on your W-2, along with the spread at exercise as ordinary income. You have no withholding for ISOs. Your broker also should have sent you a 1099-B form for sales of the stock. You report on Schedule D the gross proceeds from the 1099-B as the sales price (minus commissions) of the stock. Your 1099-B does not show withheld taxes or what you paid for the stock.

You won't be taxed twice, because you must also report your cost basis on Schedule D. Some people incorrectly use the exercise price as the basis for their NQSOs. But your basis in the stock is the amount you paid to exercise the options plus the amount of income included on your W-2 as a result of exercising the options, says Sid Blum, a CPA and CFP with Successful Accounting Solutions in Northbrook, IL. This number is usually the closing stock price on the day of exercise (or your actual sales price if you did a cashless exercise/same-day sale and your company computes your ordinary income by using the sales price).

Alert: Even when you have no income for your sale beyond what appears on your W-2, you still must report the sale on Schedule D, or you can expect a letter from the IRS (see a related FAQ).

When you sell your shares, the sales price (again, after commissions) minus your cost basis equals your capital gain or loss. The 2009 Schedule D is similar to that of the past few years. For details, see the Schedule D instructions and the annotated examples of Schedule D in our Tax Center. In some cases with a cashless exercise, there will still be a small, short-term gain or loss, depending on the commission and on how long you held the shares after the exercise. In addition, the price used for calculating the spread for your company's tax-withholding calculation may not exactly match the actual sales price (i.e., the company may use the fair market value on the exercise date, regardless of whether you did a same-day sale).

Example: You had NQSOs with a $10 exercise price, and you exercised and sold them in a cashless exercise when the stock price was $25. Your gross proceeds are $25 per share (minus any broker's commission), and your cost basis for capital gains is $25 (the exercise price, plus the $15 spread included in your compensation income). If you held the stock and sold it at $35, your capital gain would be $10.

The commission and fees you pay with your stock sale at exercise are usually deducted from your proceeds on Schedule D, not from the amount of compensation income reported on your W-2. If the 1099-B does not subtract commissions or other fees, remember to instead add them to your cost basis on Schedule D (check the trade confirmation you received soon after the sale). When your 1099-B does not state whether the amount/number is net of commissions and fees, ask your broker about this.

Editor's Note: For sales of shares acquired on or after January 1, 2011, stockbrokers will have to report to you the stock acquisition dates, your tax basis, and whether capital gains are long- or short-term. However, not until 2013 are brokers required to include in the adjusted tax basis the income you recognized from equity compensation. See IRS Notice 2009-17, the proposed regulations issued on Dec. 17, 2009, and the proposed new Form 1099-B.

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Mistake No. 3: Fouling Up Your AMT Calculation By Excluding ISOs

Sometimes people don't tell their accountants or the IRS about incentive stock options that they have exercised and held; they may believe that exercise without a sale is a nontaxable event. So they figure in good faith that the accountant or IRS doesn't need to know. Others may have forgotten about ISO exercises, particularly since the stock value isn't reflected in W-2s.

Alternatively, you may know too well about your expected AMT hit on paper profits for last year's exercise and hold. Since there is no W-2 paper trail, you wonder why your accountant or the IRS needs to know about your exercise.

The problem with this omission is that "it will make your alternative minimum tax calculation incorrect," says Jim Ciarlette, vice president and manager of the personal-tax service department at Northern Trust in Chicago. The reason: when you exercise ISOs, you don't generate current regular income, but you will have income for AMT purposes.

In addition, when the time comes to sell the stock, this is reported to the IRS. Any audit could reveal that the earlier ISO exercise and hold was not considered in the AMT calculation. Along with paying the back taxes you owe, you will pay interest and penalties too. If you cannot come up with the cash for the taxes that are due with your return for the AMT, you might want to work out a payment plan with the IRS.

Alert: Starting in 2010, the IRS will receive a notice about ISO exercises in an information filing that your company makes with the IRS. For details, see the FAQ on this.

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Mistake No. 4: Neglecting To Carry Forward Your AMT Credit

The AMT is basically a pre-payment of the tax on ISOs. IRS Form 6251 is used to figure the amount, if any, of your AMT. You report the ISO exercise spread on Line 15. Although it can take longer than you like to recover the money you paid, you get a credit for AMT in subsequent years. You need to calculate your AMT in every future year until the credit is used up, even before selling the ISO stock. Traditionally, the credit each year is limited to the amount by which your ordinary income tax exceeds your AMT, and any unused credit is carried forward (for information on the new refundable credit, see the alert below).

Some people forget about a previous year's adjustment for AMT and fail to carry credits forward to use in years when their regular income exceeds AMT income, according to Tracie Henderson, a tax partner with KPMG in Atlanta. To avoid this error, look at your past taxes and see whether you had any AMT credit eligible to be carried over into this year. If so, IRS Form 8801 is where you'll figure your credit. Form 8801 is also used to compute how much of an AMT credit, if any, you'll be able to carry forward to next year. You can download forms and instructions at www.irs.gov.

Alert: On tax returns for 2007 through 2012, for unrecovered AMT credits over three years old (e.g. for 2009, credits from 2005 and earlier), you can alternatively recover up to 50% per year of the remaining unused credit that exists when you become eligible, i.e. 50% per tax year over two years. (For tax year 2007 this figure was 20%.) Complicated phaseout rules that initially applied to higher incomes were eliminated in 2008. Unless this refundable credit provision is extended beyond 2012, it does not apply to AMT credits you create in 2009 or later, as they will not become eligible before the current term of the provision expires. (For details, see the FAQ on the refundable AMT credit.)

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Mistake No. 5: Inadvertently Overpaying AMT In The Year Of An ISO Sale

The tax rules that apply to selling ISO shares after paying AMT perplex even experts. Once you have AMT for your ISO stock, you essentially need to keep two sets of records: one for ordinary income tax and the other for ongoing AMT calculations. You must do this to properly use the credit to reduce future taxes.

ISO stock is an example of what tax experts call "dual basis assets" because it has a different basis for regular income tax and another one for the AMT. As Kaye Thomas explains in his excellent book Consider Your Options, "The AMT gain or loss on a sale of that asset won't be the same as the regular tax gain or loss. If you're not alert to this situation you may end up needlessly paying more tax than required."

As you do with any securities sale, you report the sale of the stock on Schedule D (but you also prepare an AMT version that you do not file). Capital gain or loss for your ordinary income tax will depend on the stock's exercise price and whether the stock price at sale was less than, equal to, or greater than the ISO exercise price. Your AMT basis will be higher than your regular tax basis, as it includes the spread at exercise. The key to avoid paying or calculating more AMT than is required for your ISO stock sale is also to report (as a negative amount) your "adjusted gain or loss" on Line 18 of Part I of AMT Form 6251, according to CPA Robert R. Pastore in his book Stock Options: An Authoritative Guide To Incentive And Nonqualified Stock Options.

This amount is the difference between your regular income tax and AMT capital gains. But in some situations when you are selling the stock at an AMT loss this negative amount could be restricted by the $3,000 annual limitation on capital losses. The instructions for IRS Form 6251 include a detailed example of this loss sale situation.

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Mistake No. 6: Failing To Track Stock Splits

If you exercised ISOs and the stock split before you sold, you need to ensure that your tax professional knows how many shares you were granted compared with how many you got as a result of the stock split. Otherwise, "your accountant may assume that you have a larger AMT preference than you actually do, and you'll end up paying more tax than you should," says Steven Eliach, a lawyer with Marks Paneth Shron LLC in New York. Splits also affect your tax basis (they are not a disqualifying disposition), whether they are from ISO or from NQSO exercises, ESPP purchases, or restricted stock vesting. Say the stock you're holding had a basis of $100 a share. With a 2-for-1 split, you have twice as many shares, and your basis is now $50 a share.

Mistake No. 7: Miscalculating The Taxes Due From ESPPs

Employee stock purchase plans (ESPPs) that comply with Section 423 of the Internal Revenue Code allow you to buy shares through after-tax payroll deductions at a discount of up to 15% off your company's fair market value. According to Arthur Meyers, a compensation and benefits lawyer in the Boston office of Choate Hall & Stewart, you should not include the discount in the year of purchase unless you also sell the shares in the same year. If you hold the shares for more than one year after the date of purchase, and more than two years after the beginning of the offering period, "you'll have ordinary income in the year of sale equal to the lesser of either the actual gain upon sale or the purchase price discount at the beginning of the offering," says Mr. Meyers. For sales of stock from ESPPs that are not tax-qualified under IRC Section 423, the taxation, along with the potential reporting mistakes, is similar to that for NQSOs.

The discount doesn't qualify for capital gains treatment even if you hold your stock for longer than one year. But beyond the discount, "all additional gain is treated as long-term capital gain," Meyers adds. When you don't satisfy the ESPP holding periods, you have compensation income in the year of sale equal to the spread at purchase, i.e. the difference between the fair market value of the stock on the purchase date and the discounted price you actually paid for it. See the section ESPPs: Taxes Advanced for details and examples, including a helpful FAQ on a range of ESPP tax-return mistakes.

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Mistake No. 8: Not Writing Off Worthless Securities

If you worked for any businesses that went bust, don't forget to take a loss from completely worthless company stock you own. The company must effectively be out of business, and you can't have any reasonable expectation of being able to sell your stock. If you purchased stock in such a company, your loss is equal to the amount you paid for your shares, according to Michael Massa, a CPA with the Hamilton, NJ, accounting firm of Klatzkin & Co. LLP.

You report a worthless security on Schedule D and must follow the rules of capital losses and carry-overs. For NQSOs, the value of the stock on the exercise date (i.e., exercise price plus income recognized on spread) represents your basis. Your proceeds, of course, are zero. You do not get to write off any income that you previously reported or taxes that you paid in acquiring the stock. The tax treatment is usually the same when securities fraud caused the stock to lose all or most of its value, as explained in an FAQ on that topic.

Worthless stock needs to be written off in the year it becomes worthless, and the sale date that you put on Schedule D is the last day of the relevant tax year. Otherwise, you'll need to amend your tax return to use the writeoff. You have seven years to amend your return for worthless securities, not the usual three.

Mistake No. 9: Failing To Take Advantage Of Special IRS Sections

Don Aubrey, a CPA with BDO Seidman in Menlo Park, CA, says ignorance about perfectly legal tax breaks often causes optionees to overpay their federal taxes. "Often accountants forget to ask about a lot of code sections" that are relevant to people with options and founder's stock, Mr. Aubrey says.

He cites Section 1202 and Section 1045 of the IRS Code as being especially relevant for founders and employees with stock in startups. If your company qualifies as a qualified small business corporation under Section 1202, you can exclude up to 50% of the gain on the sale of your stock up to $10 million, or 10 times the adjusted basis of that stock, if you have held it for more than five years. Under the American Recovery & Reinvestment Act of 2009, the exclusion is 75% for qualified small business stock issued between February 17, 2009, and the end of 2010. According to Mr. Aubrey, a holder of qualified small business stock can, alternatively, roll over (tax-free) any gain into another qualified small business within 60 days of the sale.

However, be careful about any so-called tax shelters for option income. Often what looks "too good to be true" catches the attention of the IRS and could subject you to paying back taxes and penalties.

Mistake No. 10: Botching The Math And Forgetting About Capital-Loss Carry-Forwards

If you've managed to avoid these first nine mistakes: congratulations. Most of the hard work is behind you. This next error is one that affects all taxpayers, particularly those who complete their tax returns manually. It may seem strange, but many blunders are purely mathematical. Look out for areas where it is especially easy to make mistakes:

• Add and subtract properly, including any capital gains and losses that are netted on Schedule D
• Compute percentages in the correct way
• Look at the right line on the tax table when figuring the amount of tax owed

Remember to use any capital-loss carry-forwards from last year, first to reduce your capital gains and then up to $3,000 of ordinary income.

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Mistake No. 11: Mechanical Errors

Now that you have avoided all the major tax-law errors, don't trip up on simple careless mistakes that can delay the processing of your tax return and subject you to IRS penalties. Even if your return is prepared by a tax professional, spend a few extra moments to check it for slip-ups. Be sure to ask questions about anything that does not make sense to you.

Tax software, and asking tax-reporting experts to review your return, can reduce many mistakes. The IRS says returns filed electronically have an error rate of less than 1% compared with a 20% error rate for manual filings. The IRS e-file and Free File services are regularly updated for changes in tax law. But even electronic filing won't catch things like transposed Social Security numbers (names on returns must match Social Security numbers in the database of the Social Security Administration).

Note that, according to the IRS, you can now file a tax return electronically even if the individual taxpayer identification number used to report wages is different from the Social Security under which the wages were earned (before, this situation required a paper filing).

IRS Publication 17 is a general manual of the rules and guidelines for completing tax returns.

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Additional Points

• Potential headache with the Making Work Pay Credit. Available in 2009 and 2010, the Making Work Pay Credit is being deployed via the tax-withholding system that employers (or their payroll companies) apply to the wages of employees, so you receive the credit in higher take-home pay. However, the credit has income phaseouts. If you had an income spike from stock grants in 2009 that your payroll department did not know of, be aware that you may have to pay taxes on the credit with your tax return unless you adjusted your salary withholding for the extra income. (For information on adjusting your withholding, see IRS Publication 919.)

  For details on this potential headache, including the new Schedule M you must file with Form 1040 or 1040A, see the related FAQ. (Taxpayers who file Form 1040-EZ must use the worksheet for Line 8 on the back of the form, as Schedule M can't be used with 1040-EZ.)

• Six-month filing extensions. For tax returns that are overly complex, or if you need extra time, the IRS has made it easier to get a six-month filing extension with Form 4868 (see a related FAQ; you still must pay any taxes you owe by the normal deadline). Even when you cannot pay what you owe, you may want to at least file, as the penalty for late filing is much bigger than the penalty for late payments.
• Schedule D cannot be attached to Forms 1040-EZ or 1040A. IRS forms 1040-EZ and 1040A do not allow the attachment of Schedule D. If you sold stock during the tax year, you will need to file IRS Form 1040. Similarly, Form 1040-EZ does not take Schedule M for the Making Work Pay Credit (see the related paragraphs above). Instead of Schedule M, taxpayers who file Form 1040-EZ must use the worksheet for Line 8 on the back of the form.
• Beware of email scams. The IRS has issued warnings about email scams involving tax refunds. Refunds do not (as many of these scams suggest) require a separate IRS form. In fact, the IRS never sends taxpayers unsolicited email and does not ask them for detailed personal and financial information by email.
• Refund status. On its website, the IRS has a tool that can give taxpayers information about the status of their refunds (Where's My Refund?). With electronically filed returns, information is available 72 hours after the IRS confirms receipt. If you file a paper return, information is available three or four weeks after submission.
• Special temporary provision for Haiti donations. In a special move, for 2009 tax returns the IRS is letting taxpayers claim deductions for cash (not property) donations made in January and February 2010 to help victims of the earthquake in Haiti. Donations that were made after January 11 and before March 1 are eligible. These donations would normally be deductible only on 2010 tax returns filed in early 2011, but now you can choose to deduct donations on either your 2009 or your 2010 tax return (but not on both). For more information, see the related IRS release.

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Lynnette Khalfani is a financial-news journalist and the author of Zero Debt For College Grads and Investing Success: How To Conquer 30 Costly Mistakes & Multiply Your Wealth!. She researched and wrote this article exclusively for myStockOptions.com. Bruce Brumberg is the Editor-in-Chief of myStockOptions.com.