Reviewed or updated January 11, 2015
It’s trickier than it should be to correctly report sales of nonqualified option stock.
Cashing in a nonqualified stock option (sometimes called a nonstatutory stock option) involves, at least from a tax perspective, two distinct transactions: you use the option to buy shares of stock, and you sell these shares. Often the two transactions happen simultaneously as a single event, but your tax return has to reflect two.
Tax reporting for the first one, exercise of the option, usually doesn’t require any special attention. Normally this event produces compensation income equal to the profit that was built into the option at the time you exercised. For example, if you paid $15 per share when the stock was trading at $20, you report $5 per share in compensation income. For an employee, this income is included in the wages reported on Form W-2, and non-employees should see it reflected on Form 1099-MISC. Unless there was a mistake by the company that granted the option, your compensation income from exercising the option will be correctly reflected on your tax return if you simply report the amounts on Forms W-2 and 1099-MISC as you normally would.
Not so the second part of the transaction. You need to report the sale of the shares, and in this case you should not trust the form you receive. You need to track down the correct information on your own.
All about that basis
When you sell stock, including stock from exercising a nonqualified option, your gain or loss is the difference between your proceeds (the amount you received in the sale, net of broker’s commission and any other expenses of selling) and your basis for the shares. You should receive Form 1099-B from the broker, providing information to you (and to the IRS) about the transaction.
One item of information on that form is the proceeds of the sale. You should be able to rely on this number. The form may also state the basis of the shares. Don’t rely on this number!
For stock acquired by exercising a nonqualified option, the basis shown on Form 1099-B will generally be incorrect. This is not the broker’s fault, but rather due to a foul-up in the way the cost basis reporting regulations were written. For background see The Sorry State of IRS Guidance on Nonqualified Options.
Since you can’t rely on the broker’s number, you’ll have to determine the basis on your own. The basic rule here is that your basis is the sum of (a) the amount you paid for the shares (that is, the exercise price of the option) and (b) the amount of compensation income you reported in connection with the exercise of the option. There are a few details that may require your attention in applying this rule, and these are explained in Stock from Nonqualified Options.
This sale of stock will appear on Form 8949. If the broker did not report basis, or you’re able to determine that the broker reported the correct basis (which is unlikely but possible), you’ll enter the correct basis in column (e) and complete the rest of the form as indicated.
The problem is how to handle the situation where you have a Form 1099-B on which the broker reported incorrect basis. Don’t panic! The IRS understands that this will frequently happen and provides a way for you to make the adjustment.
On Form 8949 in column (e) you’ll show the basis reported by the broker, even though you know it’s incorrect. In column (f) you’ll write BO, codes indicating that the broker reported incorrect basis, and that the reason was “other” (that is, other than any of the reasons for which a specific code is provided). In column (g) you’ll show the amount of adjustment to gain or loss that’s needed to arrive at the correct result.
Think negative. In the usual case, the basis reported by the broker is incorrect because the adjustment for income reported on exercise of the option is omitted. This is a positive adjustment to basis, but the form calls for an adjustment to gain or loss. Basis is subtracted to determine gain or loss, so this is a negative adjustment, which should be shown in parentheses.
Here’s an example where you exercised and sold the same day. We’re omitting the first three columns, where you would describe the stock and list the dates of purchase and sale. The exercise price of the option was $6,000, and that’s what the broker reported as the basis of the shares. The stock was valued at $11,000, resulting in a built-in profit of $5,000, so that’s the amount of compensation income you reported, and also the amount of the basis adjustment, which becomes a negative number in column (g). The proceeds were a little less than $11,000, reflecting a brokerage commission and a small discrepancy between the value used to determine compensation income and the price at which the shares were actually sold.
- Note that if you failed to make this adjustment, and instead relied on the basis reported by the broker, you would pay tax on a phantom gain of $4,948 instead of claiming a loss of $52.
You should also attach a statement explaining the adjustment, like this:
Form 8949, sale of XYZ stock, broker failed to adjust basis for compensation income reported on exercise of compensatory option.