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From the team at myStockOptions.com and myNQDC.com. this blog offers news and commentaries on equity compensation and NQ deferred comp, educational tips on the related tax and financial planning, updates about new stuff at our websites, and sometimes the lighter side of the topics we cover. We aim to please both professionals and participants, and we do our best to keep the writing lively.

29 May 2013

Cost Basis For Stock Compensation: Final IRS Rules Complicate Stock-Sale Reporting On Form 1099-B

The cost basis is the all-important number you must subtract from your stock-sale proceeds to determine the gain or loss that you report on Form 8949 of your federal tax return. At least for covered securities. the IRS Form 1099-B that your broker issues to you for stock sales does include the cost basis. For regular stock that you buy on the open market, the cost basis is the purchase price. With stock compensation, however, figuring out the basis can be tricky, as the compensation element that appears on your W-2 is part of the basis under this formula:

cost to acquire securities +

the compensation recognized by acquiring it

However, this W-2 income may not be included as part of the basis on the Form 1099-B that the IRS receives. The possible need for you to make an adjustment in the gain/loss you report on Form 8949 creates the potential for tax return mistakes and for overpaying taxes, as an incorrectly reported basis would probably be too low. (For more about the W-2 income that is part of your basis, see a related FAQ on myStockOptions.com.)

Its Comp-licated: Final Cost-Basis Rules Make Form 1099-B More Confusing When Stock Comp Is Involved

The final cost-basis regulations. which apply to equity awards granted or acquired on or after January 1, 2014, include a few important changes relating to equity compensation that differ from the treatment under the proposed regulations:

• The cost basis reported to the IRS on Form 1099-B for NQSO exercises cannot include the compensation element that is part of the basis. It can include only the exercise cost.
• Form 1099-B will not have a box, field, or other item that indicates whether the shares sold were acquired from stock compensation—a feature that would help to warn you that the basis could be too low. Initially, the IRS seemed inclined to add this type of feature to the form, but it dropped the idea in the final regulations.

According to several tax professionals, in the IRSs phrase granted or acquired the word acquired refers to the acquisition of the underlying shares. Therefore, even though a stock option award may have been granted before 2014, what really matters is the time when the shares are exercised (i.e. acquired). Given that reporting only the exercise price has always been permitted, the expectation is that brokers will conform to the reporting under the final rules by 2014 at the latest.

While brokers have not been required to report the full basis on Form 1099-B after an employee has sold shares from an NQSO exercise, a cashless ISO exercise, or an ESPP purchase, they have voluntarily started to do so. (For restricted stock and RSUs, which are considered noncovered securities, no cost basis is reported on Form 1099-B, but you still need to report the full basis on Form 8949.) However, the final regulations now prohibit brokers from reporting the full basis. According to the final regulations, the IRS found the permissive approach unworkable. As a result, the reporting on Form 1099-B is limited to the purchase price and will underreport the cost basis. The IRS seems to believe this is a better approach, as its narrative discussion in the final regulations explains:

By prohibiting adjustment by a broker, an employee will know that the basis number reported by the broker only reflects the strike price paid for the stock and that a basis adjustment may be necessary to reflect the full amount paid by the employee.

For the 2013 tax season (i.e. for sales made this year that you will report on your 2013 tax return next year), the 1099-B that the IRS receives may or may not include the full basis. You want to make sure you know whether it does. For stock acquired through equity grants in 2014, it will not include the compensation element. As a courtesy, your broker may include information in a supplemental form that helps you by including the full basis. The Tax Center on myStockOptions.com also has annotated versions of Form 8949 that explain what to do with the 1099-B information and how to properly report stock sales when the basis is too low (i.e. does not include the compensation element).