"April is the cruellest month," wrote the poet T.S. Eliot. It certainly can feel that way if you have not yet filed your federal tax return as the IRS deadline of April 15 approaches—and especially so if you are daunted by the complexity of the tax rules that apply to your income. In particular, the 2015 tax season has the potential to be more confusing than most if you sold stock in 2014.
The potential for confusion and mistakes on tax returns looms large for people who sold shares acquired from employee stock purchase plans (ESPPs), whose basic taxation is confusing enough to begin with. Understanding the important issues will help you to prevent overpaying your taxes or incurring complications with the IRS for underpaying.
The paragraphs below present some common errors (and how to avoid them) when reporting sales of ESPP shares on your tax return. See also the Tax Center at myStockOptions.com for comprehensive coverage of tax-return topics involving ESPPs and all other types of equity compensation.
Alert: If you sold stock during the tax year, you must file with your tax return IRS Form 8949 along with Schedule D, using what your brokerage firm reports to you on IRS Form 1099-B. The information on Form 1099-B has changed for stock sales made in 2014, creating special issues for stock compensation (see a related FAQ on myStockOptions.com).
1. Not filing Form 8949 after an immediate sale of ESPP shares at purchase. With an immediate sale of your ESPP shares at purchase, the discount is reported on your W-2 and on your tax return as ordinary income. Even though you never held the stock (or at least not for long) after purchase, you still need to report this sale transaction on Form 8949 and Schedule D, which are used to report capital gains and losses on all stock sales. You may even have some small gains or losses, depending on how your company calculates the discount at purchase, how long it takes for the shares to become available in your account, and any commissions and fees for the stock sale. For an annotated example showing how you report this on these forms, see a related FAQ at myStockOptions.com.
Alert: Even if you sold all of your ESPP stock immediately at purchase and all of the resulting income is on your W-2, you still must report the sale on Form 8949 and Schedule D. If the IRS were to receive a report of your gross sale proceeds from your broker (on Form 1099-B) but without a corresponding report of the sale on your Form 8949, it would think you had failed to report the gain on the sale. Assuming a tax basis of $0, the IRS computers would then automatically send you a notice about the taxes due.
2. Paying tax on the discount too early. Depending on the design of your company's ESPP, Section 423 of the Internal Revenue Code lets you buy company shares through after-tax payroll deductions at a discount of up to 15% off the fair market value of your company's stock. You should not include the discount as part of your taxable income for the year of purchase unless you also sold the shares in the same year. 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.
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 income would be reported, and would appear on your W-2, in the year of purchase, regardless of whether you sell the stock. For details and examples, see the section ESPPs: Taxes Advanced on myStockOptions.com.
3. Directly using what appears as the cost basis on your Form 1099-B. The expanded Form 1099-B does not need to report the compensation element of your cost basis, and the basis does not need to be included for stock that was purchased before 2011 (see a related article for details). This means you must check the accuracy of the basis and make any necessary adjustments in the 1099-B data on Form 8949.
Alert: If compensation income is not part of the tax basis reported in Box 1e on Form 1099-B, make an adjustment in column (g) of Form 8949. Should Box 1e be blank, report the full basis in column (e).
For annotated diagrams of Form 8949 involving ESPP stock sales, see the section Reporting Company Stock Sales on myStockOptions.com.
4. Paying the wrong tax on the discount. The discount doesn't qualify for capital gains treatment even when you have held your stock for longer than one 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, with a tax-qualified (Section 423) ESPP 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. But beyond the discount, all additional gain is treated as long-term capital gain. However, in a down market, when you sell the shares at a loss you have no ordinary income, just a capital loss.
5. Using the wrong price when there is no lookback. If your company eliminated the lookback for your ESPP, the actual discount for the purchase and for tax purposes will often differ with a qualifying disposition, adding to the potential for tax-return mistakes. Even with an ESPP that has no lookback, the purchase price discount for the taxes is still computed from the price on the first day of the offering period and not on the purchase date, as explained by a related FAQ at myStockOptions.com.
6. Paying tax twice on the discount. With ESPPs, the purchase discount is reported to the IRS on Form W-2 and is included in your income in the year of sale. Thus, when you sell the shares, do not make the purchase price your cost basis when you complete Form 8949 to report the sale. Avoid double taxation on the discount by understanding what the cost basis on your 1099-B includes and why it may be wrong (see #3 above).
You will also mistakenly double-report income if you do not realize that your W-2 income in Box 1 already includes stock compensation income. You may wrongly think it was left out because there is no tax withholding or employment tax (i.e. Social Security and Medicare) on a tax-qualified ESPP, and then erroneously report the income on your Form 1040 in the line for "Other income" (Line 21 on the 2014 form). If you do this, you will be taxing the ESPP discount twice as ordinary income. You use Line 21 only when your company mistakenly omits the income from your W-2.
For other crucial tips on tax-return reporting with ESPPs, see the full FAQ about this topic on myStockOptions.com. In addition, see other FAQs for the biggest tax-return blunders to avoid with stock options, restricted stock and RSUs, and stock appreciation rights.