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Changes In IRS Form 1040 Affect Tax Returns Involving Stock Options, RSUs, ESPPs

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As if tax returns involving stock compensation weren't complicated enough to begin with, tax-return reporting has changed yet again for the 2022 tax-return season. If you had income in 2021 from equity compensation, whether from stock option exercises, restricted stock/RSU vesting, or sales of company stock, this article explains what you need to know about IRS tax returns in the 2022 tax season.

The Changes In Brief

While the IRS Form 1040 for 2021 remains at 38 lines, changes have been made in its supporting forms. In 2018, the IRS condensed Form 1040 from its prior 79 lines in an effort to make it “postcard size.” It shifted many of those lines to supporting “schedules” that funnel information to Form 1040. The IRS has made changes in some of those schedules:

  • Schedule 1 (“Additional Income and Adjustments to Income”) is where you should enter (under the expanded entries for “Other Income”) the amount of any stock compensation you earned as an employee that was mistakenly omitted from your Form W-2. In the past, it was unclear where and how to report this income.
  • Schedule 2 (“Additional Taxes”) now has dedicated lines for amounts coming from the tax form for the Additional Medicare Tax on compensation income and the tax form for the Net Investment Income Tax (e.g. on capital gains and dividends from company stock).
  • Schedule 3 (“Additional Credits and Payments”) now has a specific line for any credit for prior minimum tax. This would apply to anyone with incentive stock options (ISOs) who has triggered the alternative minimum tax (AMT).
  • The totals on Schedule 1, Schedule 2, and Schedule 3 of Form 1040 appear on different lines on those schedules, but are entered on the same lines of Form 1040.

Highlights Of Form 1040

For the reporting of stock comp income and sales of shares, below are key aspects of the Form 1040 tax return and its associated schedules and forms, along with other details of the changes outlined above for the 2022 tax season.

1. Compensation. Stock compensation, along with salary income reported on Form W-2, is entered on Line 1 of Form 1040 (see image below).

2. Capital gain or loss. If you sold shares during the 2021 tax year, you enter each sale on Form 8949 and report the total on Schedule D. You then report that Schedule D total on Line 7 of Form 1040 (see image below). After three straight years in which capital gains reporting changed on Form 1040, it remains the same on the 2021 tax year return.

Form1040line7

For stock sales, there is still no change in the IRS rules on how the cost-basis information is reported on Form 1099-B and Form 8949. Brokers are prohibited from including equity compensation income as part of the cost basis reported on Form 1099-B. This creates tax-return confusion and complications, as only the exercise cost (i.e. what you paid for the shares) appears on the 1099-B. To avoid the risk of overpaying taxes, you need to make an adjustment on Form 8949.

For restricted stock/RSUs, confusingly, the cost basis reported on Form 1099-B is zero or the box is left blank. However, the correct cost basis is the value of the shares at vesting. That is what you need to report on Form 8949.

3. Alternative minimum tax (AMT). A concern for anyone with incentive stock options (ISOs), the AMT is calculated on Form 6251. The spread at ISO exercise is reported on Line 2i if the ISO stock was not sold in the calendar year of exercise. If the ISO stock that triggered the AMT was sold, the difference from the ordinary tax is reported on Line 2k. You enter your Form 6251 calculation on Line 1 of Form 1040’s Schedule 2 (“Tax”). You attach Form 6251 to Schedule 2. The totals from Part I of Schedule 2 go into Line 17 on Form 1040.

The AMT credit that is generated for an ISO exercise that triggers the AMT is recouped through Form 8801, as it was in the past. The amount from Line 25 of Form 8801 goes into Schedule 3 (“Non-Refundable Credits”) on Line 6b, “Credit for prior year minimum tax.” This is the first tax year the AMT credit has its own line on the schedule. The totals from Part I of Schedule 3 go into Line 20 of Form 1040.

4. Equity compensation income left off W-2. If your company does not report your employee stock compensation on Form W-2 and does not later send you a corrected W-2c, the revised Schedule 1 for the 2021 tax year indicates that the amount goes in the “Other Income” section on Line 8j (“Stock Options”).

8j

The list of items “a” through “p” (plus “z”) under “Other Income” on Schedule 1 is new for the 2021 tax year. Previously, taxpayers listed the type of other income and the amount, or put the details in a supplemental attachment. The total for other income from Schedule 1 goes into Line 8 of Form 1040.

Alert: The IRS expects you to report and pay tax on income mistakenly left off your Form W-2. An error by your employer does not release you from that obligation.

In the instructions for Form 1040 (pages 86–87), the IRS directs that the section “Other Income” on Schedule 1 is where to put any employee stock option income that is not on your Form W-2 and is therefore not reported on Line 1 of Form 1040:

Line 8j—Stock options. Enter on line 8j any income from the exercise of stock options not otherwise reported on your Form 1040 or 1040-SR, line 1.

Before this development, some tax experts thought this “Other Income” category was not for compensation-related income (only for non-wage income). Instead, they believed taxpayers needed to add the unreported W-2 income to wages reported on Line 1 of Form 1040. However, a non-match of W-2 Box 1 and Form 1040 Line 1 can raise red flag with IRS computers.

“Clearly, stock option income left off the W-2 should not be reported on the ‘wages and salaries’ line on form 1040,” explains Elliott Puretz, a CPA and retired college accounting professor in the Boston area. “From my review of Schedule 1 and the worksheets that support it, it appears that Line 8j is the line for it.”

Unresolved issues with this change in Schedule 1 include the question of how broadly to read the IRS instructions. It can be assumed to apply to all stock options, and probably ESPPs too. The IRS often uses the term exercise for purchase and refers to ESPPs as stock options. However, the instructions do not address how to handle restricted stock/RSUs. For these equity awards it is the vesting that triggers the taxable event and no exercise applies. The IRS has not yet responded to my requests for clarification.

If you are not certain that all equity compensation earned as employee left off the W-2 goes on Line 8j, then it can fit into Line 8z (“Other Income. List type and amount”). “RSUs are not stock options, so any income for those not reported as wages would presumably be reported on line 8z,” suggests Michael Gray, a CPA in San Jose (California) and a co-author of Secrets Of Tax Planning For Employee Stock Options.

8z5. IRS Form 1099-NEC for nonemployees. For employees, tax withholding occurs at NQSO exercise or restricted stock/RSU vesting, and the income should appear on Form W-2, as explained above. For nonemployees, such as consultants and directors, there is no withholding and the income from exercise or vesting now appears on IRS Form 1099-NEC (“Nonemployee Compensation”) as self-employment income. (Before 2020, it was Form 1099-MISC.)

Income is reported on Form 1099-NEC in Boxes 1 and 7. You report this income on Schedule C of your Form 1040 tax return. As the income is self-employment income, you also need to calculate on Schedule SE any Social Security and Medicare taxes that you owe.

6. Estimated taxes. The flat rate for federal supplemental withholding that applies to stock compensation (22%, but 37% for amounts over $1 million) may not cover the actual taxes you owe according to your marginal tax rate. You may have paid estimated taxes because of additional income from restricted stock/RSU vesting, an NQSO exercise, an ISO exercise/sale, or an ESPP purchase/sale. On the 2021 Form 1040, estimated tax payments are reported on Line 26.

Additional Tax-Reporting Resources

For guidance on the tax-return reporting for stock compensation and sales of company shares, including annotated diagrams of Form W-2, Form 8949, Schedule D, Form 3921, and Form 3922, see the Tax Center on myStockOptions.com.


WEBINAR: Preventing Tax-Return Errors With Stock Comp And Stock Sales

March 3, 2pm–3:40pm ET, 11am–12:40pm PT
2.0 CE credits for CFP, CEP, CPWA/CIMA, and EA

Tax-seasonThis tax season brings more risk than ever for expensive mistakes with tax returns involving stock compensation, including cost-basis reporting for stock sales.

Register for this lively educational webinar on tax-return topics for stock comp. In 100 minutes, the webinar features insights from a panel of tax experts on issues with tax returns involving equity comp and sales of company shares, including how to avoid costly mistakes. The panelists will also present real-world case studies on how to use information in tax returns to create better financial plans.

For a detailed agenda of topics covered, see the webinar registration page.

Time conflict? No problem. All registered attendees get unlimited streaming access to the webinar recording for their personal viewing, along with the presentation slide deck. Therefore, even if you have a time conflict, please still register, as you will receive a link to the recording and presentation.

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