By |Published On: Feb 20, 2023|Categories: Alternative Minimum Tax, ESPPs, Financial Planning, ISOs, NSOs, RSUs|

Avoid These 3 Tax Mistakes

Did you pay too much in taxes last year? Here are 3 common tax mistakes with stock ownership and how you can avoid them.

Equity compensation can be a great way to wealth, but you must be aware that RSUs, stock options, and ESPPs have their own set of tax implications. In general, the IRS wants their share of revenue (taxes), whenever there has been a transfer of value (income) to you. Here are three common mistakes that you might be making and what to do about them.

Not Reporting Capital Gains or Losses on the Sale of Stock

When you sell stock, you must report to the IRS that it was sold, how much was sold, what the sale proceeds were, and how much you paid for the stock. It’s very straightforward when selling non-employer stock, but too many get confused about employer stock. Taxes and withholding at vesting or exercise and how it impacts the reporting when shares are sold is confusing. You might think that because taxes were already withheld no reporting is required. However, the sale needs to be reported to the IRS. If it is not, you will receive many notices from the IRS for taxes due. Nothing gets your heart racing quite like seeing a letter from the IRS in your mail!

Your custodian (Schwab, Fidelity, etc.) sends a Form 1099 to the IRS. This document states the total gross proceeds from the sale but it is usually missing the cost basis of your stock compensation that’s included in your W-2.

Consequently, from the IRS’ point of view, there is no cost basis, and the IRS will see a very large reported gain from the sale. You can avoid this mistake by reporting stock sales on Schedule D of your tax return. Schedule D is where you indicate the amount of tax you paid on the stock compensation through payroll withholding tax. By updating the cost basis, you reduce your taxable gain and this will lower your tax bill.

Incorrect Cost Basis

Unfortunately, the Form 1099s mentioned above might have the incorrect cost basis information. If you use the incorrect information, you could pay double the tax on stock compensation – RSUs, NSOs, and ISOs that you’ve owned for less than a year.

Why are these forms often incorrect?

The IRS prohibits custodians (Schwab, Fidelity, etc.) from including the compensation income cost basis recognized by the employee on Form 1099-B.

With this in mind, the IRS is making it harder for you to file an accurate tax return.

What can you do?

Most custodians have the information available so you can avoid paying double the tax. On the tax document section of the custodian’s website, there should be a document called something like “Supplemental Tax Information.” Get this document and share it with your CPA.

If you didn’t do this in the past, it’s a good idea to review your old tax returns. If you do find a mistake in a past tax return, you have three years from the due date of the return to file an amended return.

Alternative Minimum Tax (AMT) on ISOs

Often there is Alternative Minimum Tax on ISOs if you hold your shares longer than one year after exercise – a qualified disposition. The AMT is a separate tax system than the regular federal income tax system to ensure that certain taxpayers cannot reduce their tax liability to zero.

The tax treatment of ISOs is within the AMT system. When you exercise an ISO, the IRS concludes that you have received the value of the difference between the fair market value of the company (share price or 409(A) valuation) and the strike price of the shares (lower than the fair market value). This transaction is reported on Form 6251 even though you haven’t sold the shares.

You should be very sure about the AMT tax consequences before exercising your ISOs. Sometimes, individuals can have six figure AMT bills and they are restricted from selling shares in their employers, making it almost impossible to pay their tax bill.

Stock Compensation Tax Treatment Summary

Each type of stock compensation has different tax treatment. Here is a table that illustrates each type at the various stages so you can avoid tax mistakes.

TypeGrantVestExercise Sale
No tax reporting during the start of the offering periodNo tax reporting during the purchase periodNo tax reporting at the end of the purchase periodOrdinary income tax or capital gain/loss
RSUNo tax reportingOrdinary income and withholding tax when the RSUs turn into shares of stockNACapital gain/loss
NSONo tax reportingNo tax reporting when options vestOrdinary income and withholding tax when you exercise the optionCapital gain/loss
ISO - disqualified dispositionNo tax reportingNo tax reporting when options vestOrdinary income tax, no withholding taxCapital gain/loss
ISO - qualified dispositionNo tax reportingNo tax reporting when options vestPotential AMT when you exercise the optionCapital gain/loss and AMT credit

Tax reporting for equity compensation is complicated, but if you do it properly, you can avoid many of the mistakes mentioned above. Please work with a qualified CPA who regularly works with stock compensation.

If you want to work with a financial planner who can help you make tax-conscious choices, connect you with other experts, like CPA’s, and avoid these 3 tax mistakes, feel free to set up a free consultation