Although they are called "stock options," the tax-return reporting for options is anything but optional. Whether you exercised stock options and held the shares during 2016 or sold shares acquired from stock options, the resulting income or gain must be included in the tax return that you file in 2017. As with much of equity compensation, tax issues with stock options can be tricky.
Alert: If you sold stock during 2016, 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. In most situations, the cost-basis information on Form 1099-B for stock sales from equity compensation cannot be used "as is" for accurate tax-return reporting. If you do not understand the rules, you will overpay taxes (see a related FAQ at myStockOptions.com).
Below are several mistakes to be aware of and avoid when completing your return.
1. With a cashless exercise/same-day sale, the spread is reported on your W-2 and on your tax return as ordinary income. Even though you never owned the stock after exercise, you still need to report this 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 spread at exercise and on any commissions and fees for the stock sale. For an annotated example of how to report the cashless exercise on these forms, see the FAQ on this topic at myStockOptions.com.
Alert: 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 and Schedule D, 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 for the taxes due.
2. With nonqualified stock options (NQSOs), for employees the spread at exercise is reported to the IRS on Form W-2 (for nonemployees, it is reported on Form 1099-MISC). It is included in your income for the year of exercise. (Income from an ISO disqualifying disposition, such as an early sale, will also appear.) Thus, when you report the sale on Form 8949, if Box 1e on your 1099-B reports the exercise price as the cost basis, do not list the exercise price as your cost basis without also making an adjustment in column (g). Only for ISO stock sold in a qualifying disposition will the tax basis equal the exercise price.
Alert: If the cost basis is not reported on Form 1099-B, avoid double taxation by listing the market price on the date of exercise as your cost basis in the stock. The basis should be the exercise price plus the amount of ordinary income you already paid taxes on. For an annotated diagram showing how to report the company stock sale on Form 8949 and Schedule D, see the related FAQ.
3. 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. Wrongly thinking it was left out may prompt you to erroneously report the income on your Form 1040 in the line for "Other income" (Line 21 on the 2016 form). Doing that would cause the income to be taxed twice as ordinary income. Stock comp income is included in the Box 1 amount that you enter in Line 7 of Form 1040. You use Line 21 only if your company mistakenly omits the exercise income from your W-2 or 1099-MISC.
Each type of exercise method can create its own confusion with the reporting of shares sold either at exercise or later. For example, if you sold only some of the shares in a sell-to-cover exercise, you don't want to report on your Form 8949 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.
4. With incentive stock options (ISOs), when you exercise and hold through the calendar year of exercise, remember that you need to complete an AMT return (Form 6251) to see whether you owe AMT. If the tax amount is higher than the ordinary income tax, you need to pay AMT. Your company does not send you a W-2 for this spread amount when you hold the ISO stock, so remember to do this. For more details on the AMT, see the content sections AMT and AMT Advanced.
Alert: ISO exercises in a given tax year are reported on IRS 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 receives a copy of the form, ensuring that it knows about your ISO exercise and therefore any AMT triggered by the exercise income.
5. When you have paid AMT because of your ISO exercise and hold, you get a tax credit. The rules now get even more complex. You do not need to sell the stock to start using this credit. In addition, every year until the credit is used up, you do need to complete IRS Form 8801 to calculate it, as explained in a related FAQ. Once you have sold the stock, avoid paying or calculating more AMT than is required for your ISO stock sale by reporting (as a negative amount) your "adjusted gain or loss" on Part I of IRS Form 6251. For more details, see the relevant FAQ. See also a general FAQ on mistakes to avoid on your tax return after you have paid AMT stemming from ISOs.
To read four other crucial tips on tax-return reporting involving stock options, see the full FAQ about this topic on myStockOptions.com. You may also want to read our in-depth article on tax returns involving stock options. Additionally, we have FAQs detailing the biggest tax-return blunders to avoid with restricted stock and RSUs, employee stock purchase plans, or stock appreciation rights.
If you are reporting stock sales acquired from any type of stock compensation, our FAQs with annotated diagrams of Form 8949 and Schedule D are a valuable resource to help you avoid expensive errors.