If you have equity compensation, you may wonder how the value of the shares you hold may influence your tax bill — or how vesting, exercising, and selling your shares may impact the value of your award.
The type of equity compensation matters when looking at these questions. When you have incentive stock options, the alternative minimum tax (AMT), long-term capital gains, and a qualifying sale are all important factors to consider.
If instead you have restricted stock units or non-qualified stock options, then the AMT is not an issue and the tax rules you need to understand are a little easier to follow.
In either case, much of the conversation around the tax implications of your equity compensation only addresses what happens when your shares vest (for RSUs) or you exercise your options. While these can be major taxable events, you also need to consider what the tax implications may be when shares are sold.
And to do that, you need to understand the cost basis of your equity compensation and how this impacts a taxable event when you sell your shares.
What Is Cost Basis?
The cost basis of stock is the price you paid to acquire the shares. The cost basis is important because it determines what you may or may not need to report as taxable income when you sell your stock shares.
Cost basis is important in any investment, whether through equity compensation or another vehicle, because it helps prevent being taxed on the same money twice.
To better understand how cost basis works, let’s assume that you establish a taxable, non-retirement investment account and you contribute $50 to it. That $50 is after-tax money, meaning you’ve already paid taxes on that amount.
If we assume you use this after-tax money to buy a single share of stock costing $50, that purchase price becomes your cost basis.
If the stock price increases and you sell your stock for $75 per share at some point in the future, the total proceeds you will receive will be $75. $50 of this amount is the return of your cost basis and is not taxable as you’ve already paid taxes on this amount. The $25 above the cost basis, however, is the realized taxable gain and subject to the requisite capital gains tax.
If the stock price goes down and you sell the stock at $40 per share, you have a realized capital loss of $10 per share instead. You can use this loss to offset future capital gains or against ordinary income taxes, up to certain limits.
The Impact of Holding Periods
Cost basis plays an important role in determining the taxes you owe. So too does when you purchased the shares of stock.
The taxes you pay on an investment gain are impacted by the time between the date you purchased shares and the date you sold to acquire the realized gain. That period of time determines the holding period, and will either be considered short-term or long-term.
For your investment to be considered “long-term,” you must hold the shares for at least one year past the purchase date. By doing so, you’ll be taxed at a long-term capital gains rate. That’s preferable to the short-term capital gains tax rate because it’s lower; long-term gains are typically subject to a 0 to 20% tx rate. Short-term capital gains, on the other hand, are usually taxed at higher ordinary income rates.
Equity Compensation Can Make Cost Basis More Complicated
In the example above, it’s easy to calculate the cost basis. It’s simply the purchase price of the share, or $50.
For equity compensation, however, there are many more factors that go into calculating the cost basis; you cannot rely on the purchase price of shares alone to determine it. A combination of items may come into play, including the amount per share included as ordinary income on your W-2, the amount paid for the stock via the strike price, or both.
The type of equity compensation you have matters, too. Let’s look at how cost basis can vary depending on whether you have RSUs or stock options.
Calculating the Cost Basis of Restricted Stock Units (or Awards)
Generally speaking, receiving restricted stock units doesn’t cause a reportable tax event. A taxable event does occur when your restricted stock units vest and are no longer subject to a substantial risk of forfeiture.
On the vest date, you can figure the value subject to taxes by using the following equation:
Taxable Amount = Vested Restricted Stock x Fair Market Value
So if we assume that you have 1,000 restricted stock units and they vest at $50 per share, the calculation is as follows:
1,000 x $50 = $50,000
When RSUs vest, your employer will usually withhold a certain amount to help cover your tax bill. Generally, they use a 22% rate to account for federal tax (or 37% if you have over $1,000,000 of income),. They’ll also withhold a portion to cover Social Security, Medicare, and other requisite taxes.
After withholding, employers commonly deposit shares of stock into a brokerage investment account for you. This income is typically picked up on a W-2, and income tax is withheld.
Because you are taxed on the FMV value per share at vesting, the shares you own after the vest date will have a cost basis equal to the FMV on that date. In our example above, that’s $50 per share.
Calculating the Cost Basis of Non-Qualified Stock Options
Like RSUs, non-qualified stock options are not taxed on the grant date. The intrinsic value of non-qualified stock options is taxed when you exercise your right to the option.
When you exercise, the difference between the strike price of the non-qualified stock option (NSO) and the FMV of the stock at that time is taxed as ordinary income. This amount is subject to Social Security, Medicare, and other requisite income taxes and your employer will typically withhold at the same statutory rates discussed in the RSU example above.
To see how this may play out, let’s assume you have 1,000 NSOs with a FMV of $50 per share and a strike price of $10 per share. When you exercise your NSOs, you can calculate the amount subject to taxes with the following formula:
NSO Exercised x (FMV Stock – Strike Price) = Taxable Amount
1,000 x ($50 – $10) = $40,000
Post-exercise, the cost basis of the shares that you retain will equal the price you paid for the share ($10) plus the amount claimed as ordinary income on your W-2 ($40). Therefore, the cost basis is $50 per share.
Calculating the Cost Basis of Incentive Stock Options
Incentive stock options are typically more complicated than other types of equity compensation because you may be subject to paying the alternative minimum tax. You may also need to factor in the impact of a long-term capital gains tax treatment.
If you have incentive stock options (ISOs), you should be aware of the potential for a dual cost basis. A dual cost basis means that you have a cost basis for figuring the regular income tax and a cost basis for figuring the AMT.
The cost basis for figuring your regular tax on incentive stock options is equal to the strike price of the ISO if you exercise and hold the shares (which would allow you to meet the rules for a qualifying disposition). If you sell the shares of stock prior to meeting the qualifying disposition standard, the regular cost basis may need to be adjusted based on the FMV of the stock when you sell.
The AMT cost basis is equal to the FMV of the stock when you exercise your option. AMT basis is used to calculate how much AMT you may owe in the future and how you may access AMT credits.
Calculating the Cost Basis of Employee Stock Purchase Plan Stock
Similar to incentive stock options, the cost basis of stock acquired through an employee stock purchase plan is complicated. It is not the AMT, however, that makes the cost basis of ESPP shares complicated. It is that the cost basis may be impacted by the purchase price you paid to acquire the shares of stock, the discount received (if any), and the lookback provision (if applicable).
You’ll also need to consider the timeline between the offering date, the purchase date, and the final sale date of your shares. These timelines can impact how much of your money is taxed as ordinary income and how much may be taxed as a capital asset, all of which can impact the cost basis.
If you participate in an ESPP, you may want to work with your advisor to plan for what your cost basis may be and how this will impact your after-tax proceeds received.
Using Cost Basis for Financial Planning with Equity Compensation
Knowing the cost basis of your stock is an important consideration when figuring your financial plan. This information can be useful in projecting what the tax bill of a sale of stock might be and how much after-tax proceeds you will receive.
Tax basis can also help dictate which shares to sell. All else being equal, shares of stock with a cost basis near or equal to the FMV may be more advantageous to sell than shares with a cost basis that is meaningfully less than the FMV of the stock as the smaller capital gain means a smaller tax due.
In addition to the cost basis, you’ll want to pay attention to the holding period of the stock. Shares held for longer than one year from the purchase date will be eligible for the lower-cost long-term capital gains treatment.
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