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

This tax season has the potential to be more confusing than most if you sold any stock last year.

Alert: For stock sold during 2011, you must file with your tax return the new IRS Form 8949 along with Schedule D, which has significantly changed upon the introduction of Form 8949. This change stems from the expansion of the information that brokers must report to you on IRS Form 1099-B.

By the middle of February, you should have received your IRS Form W-2, as usual. It will show any ordinary income stemming from stock options or employee stock purchase plans. If you sold shares during 2011, your brokerage will send you an IRS Form 1099-B statement, which brokers usually reformat into their own substitute statement (the IRS also receives a copy).

The information required on Form 1099-B has been greatly expanded, leading to the introduction of a new form for reporting stock sales on your tax return: Form 8949, which you must file alongside Schedule D, which itself has been revised. Form 8949 is now where you list the details of each stock sale, while Schedule D aggregates the column totals from this form to report your total long-term and short-term capital gains and losses. In addition, you will also receive IRS Form 3922 if you purchased ESPP shares in 2011 and IRS Form 3921 if you exercised ISOs in 2011.

Puzzled by what to do with your W-2, the revised 1099-B, or Forms 3921 and 3922? Don't quite know how and where to report sales of company stock on the new Form 8949 and revised Schedule D? Even if you hire someone to handle your tax return (tax specialists are helpful), you can nevertheless benefit by knowing some of the basics presented in this article about income tax reporting for company stock. The Tax Center of this website also provides annotated diagrams of Form 8949 and Schedule D.

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 related FAQs on mistakes involving stock options and ESPPs).

• Mistake No. 1: Double-counting income
• Mistake No. 2: Failing to report sales
• Mistake No. 3: Miscalculating the tax basis
• Mistake No. 4: Fouling up AMT calculation
• Mistake No. 5: AMT credit
• Mistake No. 6: Overpaying AMT in year of ISO sale
• Mistake No. 7: Miscalculating taxes due from ESPPs
• Mistake No. 8: Failing to track stock splits
• Mistake No. 9: Not writing off worthless securities
• Mistake No. 10: Failing to use special IRS sections
• Mistake No. 11: Math and loss carry-forwards
• Mistake No. 12: Mechanical errors
• Additional points, including tax credits and extensions

Mistake No. 1: Double-Counting Option Income

Don't let your W-2 trip you up. 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 showing an annotated diagram of Form W-2 for NQSOs). For ISOs, only when you make a disqualifying disposition will the income appear on your W-2, but no withholding occurs (see the FAQ showing an annotated diagram of Form W-2 for this situation).

Companies also specify NQSO income by putting it in Box 12 of Form W-2, using Code V (but not for ISOs or tax-qualified ESPPs). When you look at the line for "Other income" on your Form 1040 (Line 21 of the 2011 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. You're already including it as part of Line 7 of the Form 1040 (wages, salaries, tips, etc.). That would be painfully expensive double counting of income!

Alert: It is also easy to make the same mistake with ESPPs that are not tax-qualified, as the W-2 tax reporting is the same as for nonqualified stock options.

To double-check how much compensation came from salary versus options, compare your year-end pay stub with your W-2. The difference between the two statements should reveal your option income.

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Mistake No. 2: Failing To Report Sales

If you exercised NQSOs last year, the withheld federal, state, Social Security, and Medicare taxes will appear on your Form W-2, along with the spread at exercise, which will be treated as ordinary income. You have no withholding upon ISO exercise or a purchase in a tax-qualified ESPP, regardless of whether you held or sold shares at exercise/purchase. Also, if you sold shares during the tax year, your broker should send you IRS Form 1099-B showing the sales. Using the 1099-B, you report on IRS Form 8949 and Schedule D the sales proceeds, along with the other information from the 1099-B. While the 1099-B now includes more information than it used to, it does not show withheld taxes.

Be sure you do this reporting even for a cashless exercise in which you appear to have no additional gains on the sale and all the income is already on your W-2. In some cases with a cashless exercise, there will still be a small short-term gain or loss, depending on the commission. In special situations where your broker is not required to give you a Form 1099-B for the cashless exercise (see a related FAQ) you should still report the sale on Form 8949. As explained in the next section, about the tax basis, you will not be overreporting your income.

Alert: Even when you have no income for your sale beyond what appears on your W-2, you still must report the sale on Form 8949 and Schedule D. If you don't, you can expect a letter from the IRS (see a related FAQ). The IRS has expanded its technology over the past few years and can easily match and compare e-filed information documents (e.g. Form 1099-B) against filed tax returns.

Mistake No. 3: Miscalculating The Tax Basis

When you sell your shares, the sales price (again, after commissions) minus your cost basis equals your capital gain or loss. The revised 1099-B now reports your tax basis in Box 3. However, the cost-basis information in Box 3 of the new 1099-B may be too low, or the box may be blank. This is because the new rules for cost-basis reporting are mandatory only for stock acquired in 2011 and later, and brokers will not be required to include the compensation part of the basis until 2013. In addition, shares not acquired for cash, such as shares from a stock-swap exercise, SARs exercise, or restricted stock vesting, are considered noncovered securities.

	On Form 8949, always use the cost basis and gross proceeds on Form 1099-B. These are the figures the IRS receives.

On Form 8949, always use the cost basis and the gross proceeds shown on the Form 1099-B you get from your broker. These are the figures that the IRS receives. It is up to you—not your company, your broker, or the IRS—to make any necessary modifications on your Form 8949.

• If the cost basis in Box 3 of Form 1099-B is incorrectly reported, you make the appropriate adjustment in column (g) of Form 8949 and put Code B in column (b).
• When Box 3 is left blank, you simply report the correct basis in column (f) of Form 8949.
• If the 1099-B does not subtract commissions or other fees from the proceeds (see what's checked in Box 2), don't add them to your cost basis on Form 8949. Instead, adjust the amount in column (g) and add Code O in column (b).

See Reporting Company Stock Sales in the Tax Center for annotated diagrams of Form 8949 and Schedule D for sales involving all types of stock compensation and ESPPs.

Alert: You must accurately report your cost basis on Form 8949, making any adjustments required, to avoid being taxed twice on income already reported as part of your compensation on your W-2. Some people incorrectly use the exercise price as the basis for their NQSOs (a similar mistake lurks with ESPPs too). But your basis in the stock is the amount you paid to exercise the options (or purchase ESPP stock) plus the amount of income included on your W-2 as a result of the exercise (or purchase).

Each type of exercise method can create its own confusion with the reporting of shares sold either at exercise or later. For example, with a sell-to-cover exercise, if you sold only some of the shares at exercise you don't want to report on your Form 8949 and Schedule D the cost basis for all the shares exercised. This would result in a much larger tax basis and a capital loss for these shares sold.

For details, see the annotated examples of Schedule D in our Tax Center.

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Mistake No. 4: 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. 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. An 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 would then 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 may want to work out a payment plan with the IRS.

Alert: ISO exercises in a given tax year are reported on Form 3921 early in the following year. The form helps you collect information for reporting sales of ISO shares on your tax return. It also helps in the AMT calculation at exercise. The IRS also receives a copy of the form, ensuring that the IRS knows about your ISO exercise and therefore any AMT triggered by the exercise income. For details, see the related article elsewhere on this website.

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	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.

Mistake No. 5: 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 14. 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. 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 tax year 2011, credits from 2007 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 created 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. 6: 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 Form 8949 and 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 17 of Part I of AMT Form 6251.

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. 7: Miscalculating Taxes With ESPPs

Employee stock purchase plans 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. 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.

	Regardless of how long you hold ESPP shares, your tax basis is the purchase price plus whatever amount of income you recognized.

The full 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. 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. Regardless of how long you hold the shares, your tax basis is the purchase price plus whatever amount of income you recognized. Depending on when you purchased the stock and how your broker is reporting the compensation part of your tax basis on the revised Form 1099-B, the cost basis listed on that form may be incorrect or blank (see another article for the reason and how to handle the related tax reporting on Form 8949).

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. For all types of ESPP, see the section ESPPs: Taxes Advanced for details and examples, including a helpful FAQ on a range of ESPP tax-return mistakes.

Alert: ESPP purchases in a given tax year are reported on Form 3922 early in the following year. The form helps you collect information for reporting sales of ESPP shares on your tax return. For details, see the related article elsewhere on this website.

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Mistake No. 8: 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. Splits also affect your tax basis (they are not a disqualifying disposition), whether they are from ISO or NQSO exercises, ESPP purchases, or restricted stock vesting.

Example: The stock you are holding had a basis of $100 per share. With a 2-for-1 split, you have twice as many shares, and your basis is now $50 per share.

Mistake No. 9: Not Writing Off Worthless Securities

If you worked for a business that went bust, don't forget to take a loss from completely worthless company stock you may own. For you to obtain the loss, 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.

You report a worthless security on Form 8949 and Schedule D, and you must follow the rules on 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 Form 8949 and 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. 10: Failing To Take Advantage Of Special IRS Sections

It is easy to miss perfectly legal tax breaks, especially for people with options and founder's stock. Section 1202 and Section 1045 of the IRS Code are especially relevant for founders and employees with stock in startups. If your company qualifies as a qualified small business corporation under Section 1202, normally 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. However, under various tax changes adopted in 2010, for qualified small business stock issued between September 27, 2010, and the end of 2012, 100% of the gains may be excluded from capital gains tax (0% rate) and omitted from the AMT calculation. 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. 11: Botching The Math And Forgetting About Capital-Loss Carry-Forwards

If you've managed to avoid these first 10 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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	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.

Mistake No. 12: Mechanical 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

• 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.

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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.