The Sorry State of IRS Guidance on Nonqualified Options

By Kaye A. Thomas
Current as of January 11, 2015

The IRS doesn’t tell you much about how to report income or gain from nonqualified options — and some of what they tell you is wrong.

The tax treatment of people who exercise nonqualified options and sell the stock isn’t all that complicated. There are a few things you need to know, which differ slightly depending on whether you’re an employee (someone who receives Form W-2 showing wage income) or an independent contractor (income reported on Form 1099-MISC). The IRS has made a mess of this area, offering an explanation that dwells on confusing irrelevancies and omits key points. What’s more, some of the statements in the relevant information forms (Form W-2 and Form 1099-B) are incorrect.

Publication 525

The IRS uses Publication 525 as a catch-all for income-related topics that aren’t covered in other publications. This is where we’re supposed to look for information about nonqualified options (called nonstatutory stock options in this publication). The easiest way to pull it up is to type “Pub 525” in a search engine.

What you’ll find is a discussion that devotes much of its attention to a purely theoretical issue that is potentially confusing and of no importance to anyone. This is the issue of whether you have to report taxable income when you receive the option. Yes, this is possible — theoretically. Just not for you. Or you, or you. Or anyone else in the real world. No corporation in America grants options with “readily determinable value” as described in this publication, yet you have to wade through an extended dissection of this issue before you get to the relevant material, which is too skimpy to be genuinely helpful.

Form W-2

If you’re an employee, the compensation income you have to report will show up on Form W-2. It’s included in the total compensation number in box 1 and also broken out in box 12, identified with code V. If you examine the form carefully you’ll find an explanation of code V that tells you to look to Publication 525 and the instructions for Schedule D for information on reporting requirements. If you’re frustrated by what you find in Pub 525, you might turn to the Schedule D instructions. Don’t bother: there’s nothing at all in those instructions dealing with nonqualified options. The only options discussed there are the kind you buy and sell through a broker, which are governed by completely different tax rules than those that apply to nonqualified options. Referring people to the Schedule D instructions was simply a mistake.

Form 1099-B

When you sell the shares you acquired by exercising your option, you should receive Form 1099-B. Instructions accompanying that form include the statement, “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.” That’s another mistake. The truth is that this basis adjustment may or may not have been made. If you believe this instruction and assume the basis adjustment has not been made, you could end up applying the basis adjustment a second time, and then underpaying your taxes.

Brokers report incorrect basis, mostly

This strange situation arose from a stumble in drafting the regulations for cost basis reporting by brokers. These regs require the broker to report basis when you sell shares acquired by exercising an option after 2010. Initially they said a broker is permitted but not required to adjust basis for the amount of compensation income reported on exercise of the option. When the IRS tried to get brokers to also check a box on the form indicating whether the stock was from exercise of an option, brokers objected. The Treasury thought it was “unworkable” to leave this basis adjustment as an optional item without a checkbox telling whether it had been made. They responded with a change in the regs that provides the worst possible solution:

  • Brokers are required to report basis for these shares.
  • For options granted after 2013, brokers are not allowed to adjust basis for income from exercising the option (in other words, brokers are required to report the wrong basis).
  • For options granted before 2014, brokers are still permitted but not required to make this adjustment.

The upshot is that in nearly all cases the broker will report the wrong basis, not because the broker made a mistake, but because that’s what the regulations require for newer options, and they’ll probably want to be consistent in handling older options. To make matters worse, though, we can’t be sure whether the basis adjustment for compensation has been made, because brokers are still permitted to make the adjustment for options granted before 2014, many of which will continue in existence for many years.

Fortunately . . .

We’ve prepared detailed guidance on how to report gain or loss when selling shares acquired by exercising a nonqualified option: