If you have equity compensation, you may wonder how the cost basis of your stock and how vesting, exercising and selling your shares may impact the value of your award and your federal tax exposure. Federal taxes are discussed below; state and local taxes may vary.
Much of the conversation around the tax implications of your equity compensation only addresses what happens when, for example, your restricted stock units (RSUs) vest 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. To do that, you need to understand the cost basis of your equity compensation and how this impacts a taxable event if you sell your shares.
What Is Cost Basis?
Typically, the cost basis of the 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 if you sell your shares. Understanding cost basis is important in equity compensation 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, 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 is the realized taxable gain and subject to 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 may be able to use this loss to offset future capital gains or against ordinary income taxes, up to certain limits.
Cost basis plays an important role in determining the taxes you owe. When you purchased the shares of stock plays an important role as well. The taxes you pay on an investment gain are impacted by the time between the date you purchased shares and the date you sold the shares to acquire the realized capital gain. That period of time is 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 more than one year past the purchase date. By doing so, you’ll be taxed at a long-term capital gains rate which is lower than the short-term capital gains tax rate. Long-term gains are typically subject to a 0%, 15%, or 20% tax rate in 2024. Short-term capital gains, on the other hand, are usually taxed at the higher ordinary income rates.
Equity Compensation Can Make Cost Basis More Complicated
In the example above, it’s easy to calculate the cost basis. In general, it will simply be the $50 purchase price of the share. For equity compensation, however, there are many more factors that go into calculating the cost basis. A combination of items may come into play, including the type of equity compensation, 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 you have matters, too. Let’s look at how the cost basis can vary depending on whether you have RSUs or employee stock options.
Calculating the Cost Basis of Restricted Stock Units
Generally speaking, the grant of restricted stock units doesn’t cause a reportable tax event. A taxable event does occur when your restricted stock units vest. Assuming the restricted stock units are settled for stock, on the vesting date, you can figure the value of the underlying shares subject to taxes by using the following equation:
Taxable Amount = Vested Restricted Stock Unit 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, the value of the underlying stock is subject to federal tax withholding. Generally, your employer will withhold at a 22% rate to account for federal tax (or 37% if you have over $1,000,000 of supplemental 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 reported as ordinary income on a Form W-2, and, as noted, income and employment tax is withheld.
Because you are taxed on the fair market value (FMV) per share at vesting, the shares you own after the vesting 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 (NSOs) 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 and the FMV of the stock at that time is taxed as ordinary income. This amount is subject to Social Security, Medicare, and federal income taxes. Your employer will typically withhold at the same statutory rates discussed in the RSU example above.
So, if 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 using 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 typically equal the price you paid for the share ($10) plus the amount shown 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 (AMT). 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 the sale of shares arising from 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 is generally equal to the strike price plus any additional compensation income due upon the sale of stock.
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.
Using Cost Basis for Financial Planning
Knowing the cost basis of your stock is an important consideration when figuring out 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 may also help dictate which shares to sell. 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.
Understanding the tax implications of your equity awards can be complicated. Talk to your tax professional and financial advisor to determine. the best actions for your financial situation.
