Employee Stock Options

A stock option allows (but does not obligate) an employee to buy a specified number of shares of stock from a company for a specified price during a specified period of time. There are two categories of stock options.

  • Nonstatutory (nonqualified) stock options.
  • Statutory (qualified) stock options. Statutory stock options include incentive stock options (ISOs) and employee stock purchase plan options (ESPPs).

The employer determines the type of option offered to an employee.

The term “nonqualified stock option” is a technical term describing certain types of stock options granted to employees. The term refers to how the gain is taxed, not to the legitimacy of the transaction.

Qualified Stock Options

Qualified stock option plans offer tax advantages and must comply with specific IRS rules. For most qualified stock option plans, the employee must actually purchase the stock and hold it for at least one year before selling, after which time any gain on the sale is subject to favorable capital gain tax rates.

Nonqualified Stock Options

Nonqualified stock options have fewer restrictions than qualified stock option plans. If an employee purchases stock at a discount under a nonqualified stock option plan, the bargain element (the difference between the option price and market value) is taxed to the employee as wages at the time the option is exercised. in taxable wages, no additional steps need to be taken to report the bargain element on the employee’s tax return.

Same Day Sales

When an employer grants a stock option to an employee, the employee is often eligible for a same-day sale, allowing the employee to simultaneously exercise the option and sell the stock. In a same-day sale, the employee is not required to pay for the stock up front, but does receive cash in the amount of the difference between the exercise price and the value of the stock.

Example: Diamond, Inc. grants its employee, Dennis, a stock option to purchase company stock for $17,000. The stock is worth $25,000. Dennis chooses to cash it out in a same-day
sale. Even though he was not required to provide any payment up front, the transaction is treated as if Dennis paid $17,000 for the stock and sold it for $25,000. Dennis realizes $8,000 income.

Taxation of a Same-Day Sale

Because of an unusual quirk in reporting for a same-day stock sale, the proceeds are reported to the employee twice—once as taxable wages on Form W-2, Wage and Tax Statement, and again as proceeds from a stock transaction on Form 1099-B, Proceeds from Broker and Barter Exchanges Transactions. Every year countless taxpayers get bills for a balance due from the IRS because they
did not take the double reporting into account on their tax returns.

Form W-2

The “bargain element,” which is the difference between the exercise price and the stock value, is taxable to the employee as wages and subject to federal and state withholding. The bargain element is included in box 1 of the employee’s Form W-2, and is added to other wages on line 7, Form 1040. Since the amount is already included in taxable wages, no additional steps need to be taken to
report the bargain element on the employee’s tax return.

Code “V”

Box 12 of Form W-2 will show code “V,” which reports income from the exercise of nonstatutory stock options. This amount is already included as taxable wages in box 1. The amount listed under code “V” is informational and
is not required to be added to income.

Form 1099-B

Even though the income from the same-day transaction has already been included in wage income on Form 1040, because this was a broker transaction the employee will also receive Form 1099-B showing total proceeds
from a stock sale. Since Form 1099-B shows only the total sales price of the stock, and does not always indicate gain or loss, the transaction must be properly reported to avoid a large tax bill from the IRS.

EXAMPLE: In the Diamond example on the previous page, Dennis receives Form 1099-B showing proceeds from stock sales of $25,000. If he does not properly report the transaction, the IRS will assume he had a gain of $25,000 that was not reported on his tax return, and will send him a bill for the balance due.

Form 8949

Proceeds from a same-day transaction are reported on Form 8949, Sales and Other Dispositions of Capital Assets. Form 8949 is where the employee’s tax basis is reported which results in gain or loss from the sale of stock. Proper reporting of a same-day sale on Form 8949 will generally result in a loss equal to brokers fees and commissions, although it is possible to show a small gain
because of fluctuations of the stock price on the day of the sale.

Form 8949, Sales and Other Dispositions of Capital Assets

Taxpayers who sell stock or any other capital asset must file Form 8949. The form lists each transaction by type and totals are carried to Schedule D, Form 1040. Use Form 8949 to report the following transactions.

  • Transactions reported on Form 1099-B, see below.
  • The sale or exchange of a capital asset not reported on another form or schedule.
  • Gains from involuntary conversions (other than from casualty or theft) of capital assets not held for business or profit.
  • Nonbusiness bad debts

Example: Dennis has reported $8,000 income from a sameday stock sale as wages on his Form 1040. He also received Form 1099-B showing proceeds from the stock sale of $25,000. Dennis is computing his tax basis to determine gain or loss to report on Form 8949. His tax basis is computed as follows.

Exercise price (considered paid by Dennis)………..$17,000
Gain on exercise (reported as wages)…………………… 8,000
Broker fees and commissions…………………………………. 125
Tax basis………………………………………………………………………..$25,125
Proceeds from sale of stock……………………………………..$25,000
Less tax basis………………………………………………………………. 25,125
Loss reported on Form 8949……………………………………. ($125)

Form 1040
Line 7, Wages, salaries, tips, etc…………………………….. $8,000
Line 13, Capital gain or (loss) ………………………………… (125)