Non-Qualified Options: How to Report Stock Sales
ROB SWENSON, CPA, MST
The tax treatment of non-qualified stock options (NSOs) is quite simple. Unfortunately, filling out the IRS forms can be complicated, especially since recent rule changes went into effect.
Here are four things you should know about NSOs:
- How NSOs Work
An NSO is an option that does not qualify for the special tax treatment afforded incentive stock options (ISOs). Despite the potential tax advantages of ISOs, most employers use NSOs because they are simpler, their tax treatment is more straightforward and they avoid certain risks and limitations associated with ISOs. Let us look at an example: ABC Inc. grants its employee, Steve, NSOs to buy 100 shares of the company’s stock for $100 per share — the fair market value (FMV) on the grant date. The options vest over five years and must be exercised within 10 years. In year 5, the stocks’ FMV has increased to $150 per share, and Steve exercises all of his options, buying shares worth $15,000 (100 × $150) for $10,000 (100 × $100).
- NSO Tax Treatments
Generally, there are no tax consequences when NSOs are granted. Publication 525’s discussion of NSOs devotes several paragraphs to the circumstances under which an option grant requires you to report taxable income. This would be the case if the option itself (as opposed to the underlying stock) has “readily determinable value.”However, options granted by employers almost never satisfy this requirement. When you exercise an NSO, however, you must report compensation income equal to the spread between the exercise price and the stock’s FMV on the exercise date. Going back to the example, when Steve exercises his options, he receives $5,000 in compensation, which is taxable to him as ordinary income and deductible by his employer. It is included in wages on Steve’s Form W-2 and is subject to payroll taxes. In the case of a non-employee, income from the exercise of NSOs would be reflected on Form 1099-MISC.
- Basis for Confusion
Reporting income on the exercise of NSOs is a no-brainer. So long as the amount is reported properly on your W-2 or 1099-MISC, it should appear correctly on your tax return. Things get a bit more complicated, however, when you sell the stock. In theory, calculating and reporting gain on the sale of option stock is simple: You take the proceeds from the sale (net of any broker’s commissions or other expenses) and subtract your basis in the stock. The difference is short- or long-term capital gain, depending on how long you held the stock. Generally, the basis is equal to the amount you paid for the shares (the exercise price) plus the amount of compensation income you reported upon exercise. Suppose Steve, from the example above, holds his stock for two years and sells it for $18,000. His basis is $15,000 — the original exercise price of $10,000, plus the $5,000 he reported as wages. When he sells the stock, he will recognize $3,000 in long-term capital gain. However, here is the problem: When you sell stock, your broker sends you a Form 1099-B and files it with the IRS. The form reports your proceeds from the sale and may also report your basis. But when a 1099-B relates to stock acquired through the exercise of NSOs, there is a good chance the basis amount is wrong. The 1099-B instructions state, “If the securities were acquired through the exercise of a compensatory option, the basis has not been adjusted to include any amount related to the option that was reported to you on a Form W-2.” However, this may or may not be true.
Until recently, brokers were permitted, but not required, to adjust basis to reflect the amount of compensation income reported when options were exercised. For options granted after 2013, however, brokers are prohibited from making this adjustment. That means that for options granted in 2014 or later, the basis entered on Form 1099-B will definitely be wrong — so you will need to adjust it yourself. For options granted earlier, brokers are still permitted to make the adjustment, so you will need to calculate the basis yourself to ensure you report the right amount of gain.
Do Your Homework
If you sell stock acquired through the exercise of NSOs, do not rely on the basis reported by your broker. If you do, and the basis was not adjusted, you will overstate your gain (or understate your loss) and overpay your taxes. Determine the basis yourself and, if the amount in your 1099-B is wrong, correct it in your tax return.
Correcting Your Basis
As explained, the basis reported in a 1099-B may or may not have been adjusted to reflect amounts you reported as compensation income. If it was not adjusted, you will need to correct it in your tax return.
On Form 8949 (“Sales and Other Dispositions of Capital Assets”), enter the sale proceeds in column (d), enter the basis from your 1099-B in column (e), enter the code “B” in column (f) (to indicate that the broker reported the wrong basis), and enter the adjustment amount in column (g). Note: The form asks for the adjustment to your gain or loss, not your basis. If you are increasing your basis, you will enter a negative number here.
Should You Treat a Partner as an Employee?
In today’s competitive environment, offering employees an equity interest in your business can be a powerful tool for attracting, retaining and motivating quality talent. If your business is organized as a partnership, however, there are some tax traps you should avoid.
Once an employee becomes a partner, the IRS takes the position that you can no longer treat him or her as an employee for tax purposes. However, this has several significant tax implications.
Employees pay half of the Social Security and Medicare taxes on their wages, through withholdings from their paychecks. The employer pays the other half. Partners, on the other hand, are treated as being self-employed — they pay the full amount of “self-employment” taxes through quarterly estimates.
Often, when employees receive partnership interests, the partnership continues to treat them as employees for tax purposes, withholding employment taxes from their wages and paying the employer’s share. The problem with this practice is that, because a partner is responsible for the full amount of employment taxes, the partnership’s payment of a portion of those taxes will likely be treated as a guaranteed payment to the partner. That payment would then be included in income and trigger additional employment taxes. Any employment taxes not paid by the partnership on a partner’s behalf are the partner’s responsibility.
Treating a partner as an employee can also result in overpayment of employment taxes. Suppose your partnership pays half of a partner’s employment taxes and the partner also has other self-employment activities — for example, interests in other partnerships or sole proprietorships. If those activities generate losses, the losses will offset the partner’s earnings from your partnership, reducing or even eliminating self-employment taxes.
Unvested Profits Interests
Partnerships sometimes grant unvested profits interests to employees or other service providers. Generally, these interests are not taxable until they vest. However, if certain conditions are met, a safe harbor allows recipients to elect to pay the tax when the interest is granted rather than when it vests. Because profits interests often have low or zero value when granted, the election produces significant tax savings.
One of the conditions is that the partnership treat the recipient as the owner of the partnership interest for tax purposes from the grant date forward. However, if you continue to treat recipients as employees for employment tax purposes, you will likely disqualify them from the safe harbor.
Partners and employees are treated differently for purposes of many benefit plans. For example, employees are entitled to exclude the value of certain employer-provided health, welfare and fringe benefits from income, while partners must include the value in their income (although they may be entitled to a self-employed health insurance deduction). And, partners are prohibited from participating in a cafeteria plan.
Moreover, continuing to treat a partner as an employee for benefits purposes may trigger unwanted tax consequences or even disqualify a cafeteria plan.
If your business is contemplating offering partnership interests to your employees, consider the tax implications and potential impact on your benefit plans. Also, consider techniques that allow you to continue treating partners as employees for employment tax purposes.
For example, you might create a tiered partnership structure and offer employees of a lower-tier partnership interests in an upper-tier partnership. Because employees are not partners in the partnership that employs them, many of the problems discussed above will be avoided.