The NASPP Blog

Today we have a fabulous installment in our Ask the Experts series of webcasts, “Tax Reporting for Stock Compensation.” I thought I’d shake things up and take a look at tax filing from the employee’s perspective.

Income and capital gains associated with equity compensation can be pretty daunting for the average employee. These are my top five reporting mistakes. Your personal top five may differ based on your company’s equity compensation program and the education you provide around taxation.

No Schedule D

Employees who do not understand capital gains at all could have this problem when it comes to reporting any sale. However, it’s much more common when there is a cashless exercise or sell-to-cover transaction, particularly if the company defines the FMV as the sale price. The employee may know that the income is reported and the associated taxes are withheld by the company, assume that the exercise (or vest) and the sale are the same transaction because they happened simultaneously and not even consider the need to report the sale. Alternatively, the employee may understand that the sale price and the FMV on the exercise or vest date is the same and assume that there is nothing to report.

Partial Sale Confusion

When an employee sells only some of the shares from an option exercise or restricted stock vest, it is surprisingly easy to misunderstand what should go on the Schedule D. This is more of a problem for employees doing a sell-to-cover transaction, but can happen even if the sale is from held shares. When referencing the exercise or vest statement, the employee reports all exercised/vested shares as being sold and/or reports the cost basis for the total shares acquired as the cost basis for the shares that were sold. The most likely result is a calculation on the Schedule D that shows a sizable capital loss on the sale. Hopefully, cost basis reporting will eventually help prevent this error.

ESPP – Qualifying Disposition

Qualifying dispositions of ESPP shares are confusing because there is still (in most cases) an income element if there was a discount at purchase. Unfortunately, the most common mistake for employees is not reporting that ordinary income when or if the company fails to do so. The income element of a qualifying disposition is the lesser of the discount as if the purchase took place at the beginning of the offering period (which should now be reported to employees on Form 3922) or the spread between the purchase and sale prices. Failure by the company to report that income doesn’t exempt the employee from reporting it.

The exception is that when the sale price is lower than the purchase price, there is no ordinary income on the qualifying disposition–and that means that employees in this unhappy situation are actually more likely to report it correctly.

Reporting Gain Twice

The most common reason for this error is a misunderstanding of restricted stock vests. The employee reports $0 as the cost basis, effectively reporting the spread at vest twice: once as income and once as capital gains. This can happen with options as well if the employee uses the exercise price as the cost basis for the shares when reporting the sale. Double reporting may also happen if an employee doesn’t realize that the income resulting from a disqualifying disposition of ISO or ESPP shares is already included in the Form W-2 (assuming your company is aware of the disposition and reports it correctly).

Failure to Report an ISO Cash Exercise

Employees with ISO grants have a host of tax concepts to familiarize themselves with, but none is quite as mysterious as the issue of AMT. AMT is such a nebulous issue for most people that it is often given only a brief explanation in equity compensation communications.

Many employees hear the words “no income” and assume that is synonymous with “no reporting obligation.” However, any exercise of ISOs (assuming the shares are held at least through the remainder of the tax year) means that the employee must complete and attach Form 6251 to their tax return, even if she or he is not subject to AMT. If the employee is subject to AMT and fails to report the exercise, this is (of course) potentially a much bigger issue than if the employee simply fails to prove she or he is not subject to AMT.

So, what’s the top five for your company? If you don’t know, start thinking about it now.

Here’s a better question: How do you figure out what mistakes your employees are making? First, anything that you don’t personally understand 100% is bound to be even more difficult for employees. Also, anything comes to you as a question is a potential for a reporting problem. Keep your ears open for horror stories–if it’s happened to one person, it could happen to your employees. Finally, if you’re really ambitious, you could survey a sample of your employees with example scenarios to see if they know how to report different transactions.

-Rachel