As an advisor, how involved are you with your client’s taxation issues, such as the actual management of their yearly tax-efficient investment trades or their retirement savings? If you are highly involved, you might be helping your clients make good investment-related decisions. However, you could also be setting them up for a double-taxation possibility. One of the highest risk areas where clients could pay double taxation on the same income and never know it revolves around exercising non-qualified, granted company stock options.
So what are non-qualified stock options? They’re defined as a type of employee stock option where, when exercised, the employee pays ordinary income tax on the difference between the grant price and the exercise price of the option. They’re drastically different from incentive stock options, which have no income reported when the option is exercised (assuming certain IRS requirements are met), but then a long-term capital gain is reported when the stock is actually sold.
So where is the double-taxation possibility for your clients?
For non-qualified stock options, most investors usually exercise the option by actually buying the option at the grant price, while immediately selling the stock at the market exercise price. For my clients, this is generally recommended, once the spread between the grant price and market price is at least a 15% gain or more. The amount of gain between the grant price of the option to the actual selling market price of the stock at exercise, is the amount reported as ordinary income on an employee’s W-2, boxes 1,3, 5 as wages, with box 12, code V, denoting the specific stock option amount.
Let’s look at an example:
Five years ago, George was awarded 500 shares of Southern Company stock options at a grant price of $40/share, and he is fully vested in all 500 shares. Today he decides to fully exercise those options with a buy/sell of the 500 shares at a Southern Company exercised stock price of $50/share. The reported ordinary income is the difference between the $40 (grant price) and $50 (exercise price) or $10/share gain, which equals $5,000 in ordinary income, taxed as W-2 wages.
As noted above, the $5,000 would be added to boxes 1, 3, and 5 of George’s W-2 wages (assuming he has not already earned above the FICA wage limit of $118,500). Also, the $5,000 would be reported in box 12, code V, to denote the source of the income was from non-qualified stock options.
I’m guessing everyone who walked through the above example is wondering, ‘Where’s the possibility of double taxation?’ as it seems fairly straightforward. The example is pretty much error-proof up to the point I stopped the example, but here’s where things get complicated.
With every client I’ve ever had with non-qualified stock options, the custodians or broker-dealers hired to administer these company benefit plans send out 1099-Barter proceed statements on these exercised options every year, as they are required per IRS rules.
However, I’ve found they’re usually incorrect. I’ve yet to see one broker-dealer or custodian correctly report the exercised capital gain/loss of non-qualified stock options as only a short loss for the commissions paid on the exercise.
Most broker dealers or custodians actually report the 1099-Barter proceeds (based on my example above) as a $5,000 short-term capital gain, which is incorrect for non-qualified stock options. The $5,000 is only taxable as ordinary income, and not additionally as a short-term capital gain. While the 1099 Barter proceeds are reporting the sale transaction as any normal non-qualified stock sale transaction or an incentive stock option transaction, they are not adjusting them correctly, due to the source being non-qualified stock options.
As you can see, your clients’ non-qualified stock options exercised will be reported correctly as ordinary income on their W-2, but also have a high chance of receiving a 1099 tax filing document, reporting it as an additional short-term capital gain. If this is filed on a client’s tax return as the tax documents depict, it will subject the short-term gain to an additional ordinary income tax, hence taxation on $10,000 instead of only $5,000 = double taxation.
Therefore, if you aren’t involved in your clients’ tax issues or if you have clients exercising stock options and filing their own tax returns, I urge you to share this article with them, or provide them some expert tax advice and help save them some money in taxes. I assure you they’ll love the advice and especially the tax savings.