Please take note of the following cost basis reporting change affecting clients who sell stock acquired through the exercise of stock options. Starting in 2014, brokerage firms are no longer allowed to increase the cost basis of shares acquired through option exercise to account for the compensation component included in ordinary income. In other words, brokerage firms will only be reporting the exercise price as the cost basis. If the basis reported by the brokerage firm is not adjusted for the imputed ordinary income, the gain or loss upon the sale of the stock acquired may be incorrect.

Cost Basis Reporting Change for Stock Options

For example, Val U. Employee exercises a non-qualified stock option in 2014. The exercise price is $100 and the fair market value at the time of exercise is $1,000. The imputed income of $900 is included in wages (Form W-2, Box 1 and Form W-2, Box 12, Code V). Val’s basis is the amount paid to exercise of $100 plus the imputed income of $900 for a total of $1,000. However, the brokerage firm will only be reporting $100 for the cost basis reporting. Val must adjust this basis by the $900 when reporting the transaction on her 2014 income tax return.

Historical Perspective

The proposed regulations provided that a brokerage firm was permitted, but not required, to increase a customer’s initial basis in stock for income recognized upon the exercise of a stock option. During the comment period, the broker community indicated that compensation information is not necessarily accessible to all brokerage firms. They also expressed concern that, in many situations, the brokerage firm would have to accept customer-provided information in order to track the proper cost basis reporting. The lack of a mechanism to communicate whether the basis of stock has been adjusted for the exercise of a stock option coupled with a system involving discretionary broker adjustments for stock options would be unworkable.

After consideration of the comments, the Treasury Department and the IRS agreed that the compensation component related to the exercise of stock options should not be added to the Form 1099-B. Accordingly, the final regulations provide that brokerage firms are not permitted to adjust basis to account for the exercise of a stock option that is granted or acquired on or after January 1, 2014. This approach is intended to eliminate confsion and uncertainty for an employee who has exercised a stock option. By prohibiting adjustment by the brokerage firm, an employee will know that the basis reported on Form 1099-B only reflects the exercise price paid for the stock and that a basis adjustment may be necessary to reflect the full amount paid by the employee.

Please contact your Untracht Early advisor if you have questions on cost basis reporting and stock options.

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