Since cost-basis data won’t show up on Forms 1099-B until January 2012, this probably seems like something you don’t need to worry about right now. But the data you are transmitting to your brokers beginning this January could impact what is reported on Forms 1099-B next year. In light of this, I have four questions you should ask your brokers now about their plans for compliance with the cost-basis reporting requirements.
1. What is the broker planning to report as the cost-basis for shares acquired pursuant to NQSOs? Brokers are only required to report the purchase price as the cost basis but can voluntarily report the full cost basis. More importantly, are your brokers looking to you to provide the cost basis? If so, perhaps you can avoid some of the mess (and potential for employees to double tax themselves) that Rachel Murillo describes in her Nov. 18 blog entry “Paving the Way for Cost-Basis Reporting Now,” by providing the full cost-basis (price + income recognized), so that the correct basis is reported on Forms 1099-B in 2012. This could be a life-saver for your employees in terms of getting their tax returns correct and for you (and your broker) in terms of the amount of employee education necessary and inquiries that have to be fielded.
2. Ditto for shares issued under restricted stock units and awards. These are considered non-covered securities, so brokers don’t have to report any cost-basis data for them at all, but as with NQSOs, brokers can voluntarily report. Having that data on Form 1099-B could be a big help for employees–if it is correct, of course. If you provide your brokers with the correct cost basis for shares issued under awards, will they report it on Form 1099-B for your employees?
3. Ditto for shares acquired under ISOs and ESPPs. Here, however, things are more complicated because employees often recognize ordinary income at the time of sale, resulting in a stepped up basis that isn’t known until the sale occurs. In some cases, it is literally impossible for you to pass the correct basis to your brokers at the time the shares are acquired. But, in other cases, you might be able to make an educated guess. What makes the most sense to pass as the cost basis? For ESPPs, the FMV at purchase would be the right basis if employees engage in disqualifying dispositions but will be wrong for qualifying dispositions. But, the purchase price is almost always wrong, for both qualifying and disqualifying dispositions (the only time it is the correct basis is for qualifying dispositions where the shares are sold at a loss). For ISOs, FMV at exercise will be the right basis for disqualifying dispositions only if the shares are sold at a price higher than this amount. For qualifying dispositions of ISOs, the exercise price is the correct basis. Where does this leave you in terms of the data you pass to your brokers–now would be a good time to ask, before you start transmitting all this data.
4. How should you transmit this data to your brokers? I understand from the recent Stock & Option Solutions webcast, “Cost Basis Confusion: What Do the New Regulations Mean for Stock Plan Professionals?,” presented by Elizabeth Dodge of SOS and Andrew Schwartz of BNY Mellon Shareowner Services, that issuers may be able to use the DTCC’s Cost Basis Reporting Service (CBRS) to transmit cost-basis data for shares acquired through stock plans. Do your brokers want you to use this service and, if yes, how will you get training on it? If no, what method will you use to transmit this data to them?
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The upcoming tax season is shaping up to be a confusing one for your plan participants. They will be receiving new bits of information regarding their equity transactions, all intended to be helpful. The problem with information is that it’s only helpful if you can understand it. As your company gears up for your Section 6039 reporting, don’t push cost basis reporting off as an issue that can wait until 2011 year end.
As Barbara pointed out in her June 2nd blog entry, requirements for cost basis reporting come in phases and 2011 marks the first phase. For regular stock sales, this will be very helpful. For equity compensation, however, this first phase actually provides misleading information. The cost basis that is required to be in Box 3 of the new Form 1099-B is only the purchase price of the shares, not the actual cost basis. While it is permissible for brokers to go above and beyond the requirement ahead of schedule, I doubt that it will be feasible for, especially for sales of ESPP shares, to put processes in place to capture and incorporate the necessary information to report the true cost basis for all sales in 2011.
Tower of Babel
What the communication quagmire boils down to is that employees are receiving an increasing number of communications with numbers that represent some piece of their tax puzzle, but not all the numbers will match or even be relevant. The message to your seasoned employees can be simple and clear: There is absolutely no change in the way you need to report your income or capital gains. This is true for both the Section 6039 information statements that employees may receive for this upcoming tax season as well as the changes to 2011 Forms 1099-B. Your new employees or those who still haven’t fully grasped the concepts behind tax reporting, on the other hand, will need to be given the resources to avoid making costly mistakes.
Double Trouble
Just to review, let’s talk about an NQSO exercise. At exercise, the employee realizes income on the difference between the exercise price and the FMV on the exercise date. For example, if 100 shares of an option were exercised for $10 per share when the FMV is $15 per share, the employee would pay an exercise price of $1,000 and realize ordinary income of $500. The new cost basis for these 100 shares is the exercise price plus the income, which is $1500 or $15 per share.
If the exercise in this example takes place in 2011 and the employee sells 11 shares to cover the taxes due, she or he will receive a Form 1099-B from the broker for the 11 shares showing a cost basis of $10 per share. Leaving the fees and commission on the sale out of the conversation, this means that the employee could easily misunderstand and pay capital gains taxes on that same $5 per share that is reported as income on his or her W-2–effectively paying taxes twice.
The Broker Connection
Brokers are making changes to their back-end systems and the user interfaces to accommodate lot ID for sales of shares. Some brokers already have electronic lot selection for some or all brokerage accounts, but the functionality may not yet apply to shares from employer equity plans. You will want to work closely with your broker(s) to understand what any changes will look like for employees, especially if there will be enhanced modeling features. Get educated on how the broker will determine which lot of shares is being sold through employee accounts and if or how employees can designate specific lot sales when selling online.
Now is also a perfect time to provide information to employees on the acceptable methods for determining cost basis of shares and how to plan for tax filing before they engage in a sale. Many brokers have information and FAQs already available that you can leverage to educate your employees.
Because cost basis reporting is only required for sales of shares that were acquired on or after January 1, 2011, you’ll also want to know what your broker is planning to do about reporting for shares purchased prior to 2011.
Break it Down
If possible, provide your employees with an FAQ that illustrates the cost basis of shares sold from each type of equity award that you offer this year so that next year’s conversation won’t mean starting from scratch. If you need a refresher in any of these, the Conference session, “IRS Cost-Basis Reporting: Are Your Stock Plans Ready?” includes a great list. By working to get employees familiar with the term “cost basis” right now, you help them with their tax reporting for this year, making next year’s conversation easier. If you issue ISOs or have an ESPP, any discussion of cost basis must include a refresher on qualifying vs. disqualifying dispositions, which works perfectly into any plans you have in place for educating employees on the Section 6039 information statements they’ll be receiving.
Just in the nick of time, the IRS has released the final regulations for cost-basis reporting on Form 1099-B, the first phase of which goes into effect for stock sales occurring on or after January 1, 2011. Thanks to Andrew Schwartz of BNY Mellon Shareowner Services for providing the NASPP with an alert explaining how the regulations apply to stock compensation.
Final Regulations on Cost-Basis Reporting Andrew’s alert covers the key impacts to stock compensation in just two pages, but for those of you that still don’t have time to read it, I provide a few highlights below.
What the…?
Hopefully this hasn’t caught you by surprise, but, in case it has, here’s a refresher. The Economic Stabilization Act of 2009, as a revenue-raising measure, requires brokers to include cost-basis information on any Forms 1099-B reporting sales of securities (stock, options, etc.)–see our earlier alert “Cost Basis Reporting to Impact Stock Plans.” The requirement is phased in over several years; the first phase, which applies to sales of stock, is effective beginning in 2011.
If you are wondering how this will raise revenue, given that the most common mistake employees make when reporting stock sales on their tax returns is to underreport their basis, so was I. That is until I realized that the way the requirements are phased in for stock compensation is actually likely to increase the likelihood that employees will underreport their basis, at least for the first few years. See my June 2, 2010 blog entry, “Cost-Basis Reporting: Complicating an Already Confusing Topic.”
The Final Regulations
Under the final regulations, as under the proposed regulations, cost basis will have to be reported for any sales of stock acquired on or after January 1, 2011. This includes stock acquired through option and SAR exercises, ESPPs, and restricted stock and unit awards. The final regulations carve out an exception for stock that isn’t acquired “for cash.” For our purposes, this includes restricted stock and unit arrangements and also most likely SSARs, because employees do not pay cash to acquire shares under those types of awards. For stock acquired under options and ESPPs, where employees are required to pay for the stock, the broker must report a cost basis at least equal to the amount the employee paid for the stock (the cost basis also includes any ordinary income recognized in connection with the stock, but brokers aren’t required to include this in the cost basis until 2013–hence the likelihood for underreporting).
Unfortunately, the regulations don’t do much to address the complications involved in reporting the cost basis for shares acquired under an ISO or ESPP, which often can’t be fully calculated until the shares have actually been sold.
Why Do You Care (If You Aren’t a Broker)?
I know that it feels like this is something that only applies to brokers but the fact is that these requirements are likely to have an impact on stock plan administration, from additional data that your brokers and transfer agents are going to need from you, to employee confusion, to higher fees that brokers and transfer agents are charging to pay for the additional infrastructure necessary to fulfill the reporting requirements. If you haven’t yet discussed these regulations with your brokers (and transfer agents, this implicates them as well), now is the time to have that conversation.
Conference Audio Available Andrew moderated a great session on this topic at the 18th Annual NASPP Conference, “IRS Cost-Basis Reporting: Are Your Stock Plans Ready?” If you missed it and want to know more about cost-basis reporting, you can purchase the recorded audio for this and any other Conference sessions in downloadable MP3 format. Purchase just the session(s) you want or save by purchasing a package of sessions.
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Cost-Basis Reporting: Helpful Information or Disaster Waiting to Happen? Cost-basis reporting on Form 1099-B will be required for sales of any equity securities acquired after January 1, 2011. This includes sales of shares acquired under stock option, restricted stock/unit, and other stock plans, as well as shares acquired under ESPPs. But the rules apply slightly differently to shares acquired under these plans than for, say, shares acquired via a run-of-the-mill open-market purchase. The end result is likely to be a lot of confusion, a lot of employee inquiries, and, probably, a lot of overpayment of taxes.
Understanding Cost-Basis for Equity Compensation
For shares acquired through an open-market purchase, the cost basis is simply the amount paid for the shares plus any transaction fees (including fees for the sale transaction, if the broker doesn’t report the sale proceeds net of fees on Form 1099-B). But for shares acquired under a stock compensation program, the cost basis also includes any income reported on the employee’s Form W-2 in connection with either the purchase or the sale of the shares.
Maybe You Should Install a Second Phone Line
The proposed regulations on cost-basis reporting, however, only require brokers, et. al., to report the amount paid for the securities as the cost basis on Form 1099-B. Regulations requiring brokers to report the full cost basis won’t be effective until 2013 at the earliest. For stock compensation, this seems like a huge flaw in the reporting requirements.
If, as a stock plan administrator, you’ve been thinking that you don’t need to worry about these rules because it isn’t your job to issue Forms 1099-B, think again! I can only imagine how confusing this will be for employees–who are already pretty confused about how to report stock compensation on Schedule D. Unless you have some top-notch communications about this, you’ll need to be prepared for a lot of employee confusion and inquiries. And this goes for brokers too–employees are just as likely to look to the broker that issued the Form 1099-B for answers as they are to look to their company’s stock plan administrator.
Now I Understand the Additional Tax Revenue
I suspect that many employees will simply report the Form 1099-B cost basis on their Schedule D, not realizing that this is an understated amount. This will cause employees to pay capital gains tax on the amounts that have already been taxed at ordinary income rates. If the sale is less than a year after the stock was acquired (as in the case of a same-day sale exercise), it is a short-term gain, taxed at the same rate as ordinary income. This doubles the federal income tax paid on the transaction–for employees in the highest tax bracket, it could result in taxes paid of more than 80% of the spread.
I’ve been trying to figure out how cost-basis reporting is going to generate so much additional tax revenue, but now I think I understand.
And, if by some miracle, employees do manage to report the correct tax basis on their tax returns, what happens when the cost basis reported on Schedule D doesn’t match the basis reported on Form 1099-B? Currently, if there is a discrepancy in the sale proceeds reported on Schedule D vs. Form 1099-B, this triggers an automatic IRS notice that there is an error on the return. Will the same type of notice be generated if the reported cost-basis amounts don’t match? If so, how will employees explain the discrepancy to IRS auditors–who probably don’t understand cost-basis for equity compensation any better than they do?
Do You Know What Your Brokers Are Doing?
As I understand it, brokers are permitted to go above and beyond the minimum reporting requirements. If they have the full cost-basis information available and are so inclined, brokers can report the full cost basis (amount paid plus amounts included income) on Form 1099-B. Now would be a good time to ask your brokers a few questions about how they plan to comply:
What will they report as the cost basis for shares acquired under various types of stock compensation arrangements? Ask specifically about NQSOs, restricted stock/units, ISOs, and ESPPs if you offer all of these arrangements.
What sort of communication materials are your brokers going to provide to employees to help them understand the information reported on Form 1099-B and how will this information be provided? Will they actively distribute information to employees or will employees have to ask for it?
Thanks to Andrew Schwartz at BNY Mellon Shareowner Services for providing the background information on how the cost-basis reporting requirements apply to stock compensation. Be sure to check out Andrew’s interview on cost-basis reporting in the upcoming issue of The NASPP Advisor.
18th Annual NASPP Conference Don’t miss the 18th Annual NASPP Conference from Sept 20-23 in Chicago. We just posted this year’s program and it is phenomenal–we’ve planned over 40 sessions on critical and timely topics, like cost-basis reporting. Register for the Conference today.
NASPP “To Do” List We have so much going on here at the NASPP that it can be hard to keep track of it all, so I keep an ongoing “to do” list for you here in my blog.