Tax returns are notoriously tricky when they involve income from equity compensation: stock options, restricted stock or restricted stock units (RSUs), employee stock purchase plans (ESPPs), and sales of company stock. Mistakes can lead to overpaid tax, overreported income, IRS penalties, or even an IRS audit.
The myStockOptions webinar Preventing Tax-Return Errors With Stock Comp And Stock Sales, held live on March 3 and now available on demand, featured insights from a panel of tax experts and financial advisors on how to avoid errors with tax returns involving income from equity compensation and sales of company shares. Below are four costly tax-return mistakes to avoid, with some of the commentary they provided during the webinar.
Mistake #1: Not Reporting Stock Sales On Form 8949/Schedule D
After you sell stock during the tax year, you must complete IRS Form 8949 when adjustments are needed, and then Schedule D. Form 8949 is 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. You take the total capital gain or loss on Schedule D and enter it on Line 7 of your Form 1040 tax return.
STOCK-SALE REPORTING: Details of each sale go on Form 8949; Schedule D aggregates the capital gains … [+]
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Even with a cashless exercise of stock options in which all the income appears on your Form W-2 and you seem to have no additional gains on the sale, be sure you report the sale. In some cases with a cashless exercise, you may have a small short-term gain or loss, depending on how your company calculates your exercise income and the brokerage commission. What if there actually is no additional income from your sale beyond what’s on your Form W-2? You still need to report that sale on Form 8949 and Schedule D.
The IRS has expanded its technology over the past few years. Its computers can easily match and compare e-filed information documents (e.g. Form 1099-B) against filed tax returns. If you don’t report these sales, you can expect a scary letter from the IRS (CP2000 Notice) about owing taxes on the full amount of the proceeds from the unreported stock sales.
What should you do if that happens? “We send a response with all the supporting documents,” said webinar panelist Dan Hodgin, a CPA and the owner of Silicon Valley Tax Group. “It basically says hey, this is what happened, this is why we think your notice is incorrect, and here are the attached supporting documents. If that doesn’t work, we’ll amend the return. But a lot of times, with just a response the IRS will adjust it in its computers and will issue an updated notice with corrected terms.”
Mistake #2: Not Reporting Your Cost Basis Correctly
The cost basis, sometimes called the tax basis, is the full cost of acquiring a security. This is a big area for potential errors on tax returns, made more likely by confusing IRS rules that apply to stock compensation. When you sell shares, the sales price (after commissions) minus your cost basis equals your capital gain or loss:
NET PROCEEDS – COST BASIS = CAPITAL GAIN OR LOSS
If the cost basis is too low, you overpay taxes.
Form 1099-B reports your cost basis in Box 1e (your broker’s substitute statement will use columns with the same numbering), without including any compensation income you recognized from equity awards. This means the cost-basis information reported to the IRS in Box 1e of Form 1099-B may be too low, or the box may be blank.
In addition, brokers are prohibited from giving any cost basis for shares that were not acquired for cash (i.e. “noncovered securities” in IRS parlance). That includes shares acquired at vesting from a grant of restricted stock/RSUs or in a stock-swap option exercise.
Unfortunately, this confusing situation is rife for mistakes on tax returns. When reporting sales of shares that were acquired from restricted stock or RSUs, taxpayers may wrongly think the cost basis is $0. That is because on Form 1099-B, Box 1e for the cost basis will probably be blank or show $0.
However, your cost basis is the amount of income included on your Form W-2 in the year when the restricted stock/RSUs vested. As illustrated by annotated diagrams of Form 8949 and Schedule D at the website myStockOptions.com, instead of putting $0 in the cost-basis column (e) of Form 8949 and then making an adjustment in column (g), you put the correct full basis in column (e).
How can you keep track of your cost basis accurately? During the webinar, panelist Stephanie Bucko, a CPA and the co-founder of Mana Financial Life Design, recommended taking screenshots during the stock-selling process as an extra record of “exactly what happened at that time.” Dan Hodgin added that “most of the brokerage houses will give you supplemental information along with your Form 1099-B, so that’s a roadmap to make sure everything is correct.”
Dan suggested paying attention to the number of short-term capital gains you have. Having a lot of short-term sales “usually is a red flag that there needs to be an adjustment in the cost basis.” He also said that his firm checks Form W-2 for the difference between Box 1 (total of ordinary income) and Box 3 (Social Security and Medicare wages). “When there’s a difference there, that may be an indication that there’s some income in your W-2 that needs to be adjusted on your Form 8949.”
Dan also cautioned against moving stock compensation shares out of the original stock account that they’re in. “That’s when big mistakes happen, in my experience.” He observed that moving the shares from the account at the brokerage firm your company uses for its stock plan can cause the loss of historical data that you will later need to provide the correct cost basis for your tax return.
CFP and EA Daniel Zajac, the managing partner of Zajac Group, emphasized the importance of communication between your tax preparer and your financial advisor to ensure the cost basis is correct. “This is where coordination between an accountant and a financial advisor adds a lot of value,” he explained. “We’re working with the client throughout the year. It’s easier for an accountant to have a conversation with the financial advisor as opposed to figuring out the cost basis on the back end.”
Mistake #3: Double-Counting Income From Form W-2
Don’t get confused by your Form W-2 and overreport income. When you exercise nonqualified stock options (NQSOs), the difference between your exercise price and the stock’s market price is ordinary income, even if you hold the shares and don’t immediately sell them. That ordinary income for employees is included in Box 1 of your Form W-2 and in the other boxes for state and local income, Social Security up to the yearly maximum, and Medicare, along with the amount withheld. When restricted stock/RSUs vest—again, even if you don’t sell any shares—the value of those shares is ordinary income and included in Box 1 of your W-2 with your other compensation and in the other boxes for state and local income.
That’s pretty straightforward. Here’s where it gets tricky. Companies also must single out income from NQSOs and nonqualified ESPPs by putting it in Box 12 of Form W-2, using Code V. For other equity grants, some companies voluntarily report stock compensation income in Box 14.
Therefore, don’t make the mistake of separately reporting the amount that appears in Box 12 of your W-2 or that may appear in Box 14. It’s already included in the Box 1 income that you report on Line 1 of Form 1040. Adding it on top of the income already reported would cause that income to be taxed twice.
To double-check how much compensation came from salary and how much from options or RSUs, compare your year-end salary paycheck stub with your W-2. The difference between the two statements should reveal your stock comp income.
Webinar panelist Stephanie Bucko actually logs into the brokerage account with her clients to recover the necessary documents and information. “We’re always tracking their balance sheets to make sure we have a full list for when they’re providing their CPA with the documents for the tax return.”
Dan Zajac echoed the importance of historical data on various forms for his clients at tax time, not only for their tax returns but also for their financial planning. “It’s all about data-gathering,” he said during the webinar. “We’re having the conversation about goals, objectives, risk tolerance, investments. But on the flip side, we’re looking for actual data. Give us statements, tax returns, pay stubs, W-2s, and everything. For people with equity comp, we want to see where you are now, but it’s equally important to understand what’s already happened. We need all those pieces of the puzzle. After we’ve reviewed the previous year’s tax return, what can we do to plan for the next year?”
Mistake #4: Forgetting About The Share Withholding For Restricted Stock/RSUs
For tax withholding when a grant of restricted stock/RSUs vests, many companies require shares to be automatically held back to cover the taxes, or at least make it the default method. “It’s definitely confusing for people,” said Stephanie Bucko. “They think they’re vesting, say, 2,000 shares and then they receive only 1,200 in their account.”
Should you report withheld shares on your tax return? In general, if you do not receive a Form 1099-B for the shares withheld, most tax preparers do not report them. “For the most part, brokerage houses do not report the withheld shares on a 1099-B,” confirmed webinar panelist Dan Hodgin. However, when there is an actual same-day sale of shares to cover the taxes, you do always report the stock sales.
After you have later sold the shares that you received from that grant, remember to exclude from your Form 8949 those shares that were withheld for taxes (i.e. do not use the full number of granted shares). Otherwise, you will later report on your Form 8949 and Schedule D more shares than you actually sold.
More Pro Tax-Return Tips
For more expert insights on tax returns involving stock compensation, including incentive stock options (ISOs) and the alternative minimum tax (AMT), see the Tax Center at myStockOptions.com, a website dedicated to equity compensation and the related tax/financial planning. The webinar that features these tax experts, Preventing Tax-Return Errors With Stock Comp And Stock Sales, is available on demand at the myStockOptions Webinar Channel.