How to Calculate Stock Option Cost Basis
The cost basis for employee stock options is often misreported on tax forms. Learn the correct calculation to ensure you report accurate capital gains and pay the right tax.
When you sell shares acquired through an employee stock option plan, calculating your profit or loss involves more than just subtracting your purchase price from the sale price. The central element is the “cost basis,” which represents your total investment in the stock for tax purposes. Properly determining this basis is necessary for accurately calculating the capital gains tax you owe. The method for calculating cost basis differs significantly depending on whether you received Non-Qualified Stock Options (NSOs) or Incentive Stock Options (ISOs).
Information Needed to Determine Cost Basis
The first step is to identify the type of options you have. This information is located in your stock option grant agreement or the associated plan documents provided by your employer; these documents will explicitly state whether the options are NSOs or ISOs.
Next, you will need the details of your option grant. This includes the grant date, which is the day the options were issued to you, and the strike price, also known as the exercise price. The strike price is the fixed price at which you are entitled to purchase the company’s stock and is a component of your cost basis calculation.
You also need information from the date you exercised your options. The exercise date is the day you officially purchased the shares. You must know the Fair Market Value (FMV) of the stock on this specific date. For a publicly traded company, the FMV is the market price on that day, while for a private company, this value is determined by a formal valuation and should be communicated to you by your employer during the exercise process.
For NSOs, you need the amount of compensation income you recognized. This income, which is the difference between the FMV at exercise and your strike price, is considered ordinary income. You can find this amount reported on your Form W-2. For ISOs, your employer will provide Form 3921, which contains the necessary dates, strike price, and FMV at exercise.
Calculating Cost Basis for Non-Qualified Stock Options (NSOs)
The cost basis calculation for Non-Qualified Stock Options (NSOs) is designed to ensure that you are not taxed twice on the same income. When you exercise NSOs, the difference between the stock’s Fair Market Value (FMV) on the exercise date and the strike price you paid is considered compensation. This amount, often called the “spread” or “bargain element,” is taxed as ordinary income, and your employer typically withholds taxes at the time of the transaction.
Because this compensation element has already been taxed as ordinary income, it is added to your cost basis for the shares. The formula is to multiply the number of shares purchased by the strike price, and then add the total compensation income reported on your W-2.
For example, imagine you exercise 100 NSOs at a strike price of $10 per share when the stock’s FMV is $50 per share. The total amount you pay to the company is $1,000 (100 shares x $10). The compensation income recognized is $4,000 (($50 FMV – $10 strike price) x 100 shares). Your cost basis for the 100 shares is therefore $5,000 ($1,000 paid + $4,000 compensation income).
Calculating Cost Basis for Incentive Stock Options (ISOs)
Calculating the cost basis for Incentive Stock Options (ISOs) is more complex because it requires you to determine two separate basis figures: one for regular income tax and another for the Alternative Minimum Tax (AMT). This dual-basis system exists because the tax treatment of ISOs differs significantly between the two tax regimes.
For regular tax purposes, the cost basis calculation is simple. It is the number of shares you purchased multiplied by your strike price. Unlike NSOs, there is no compensation income recognized at the time of exercise for regular tax calculations, provided you hold the shares long enough to meet the requirements for a “qualifying disposition.” This means you do not sell the shares until at least two years after the grant date and one year after the exercise date.
The calculation for the Alternative Minimum Tax, however, is different. The “bargain element”—the difference between the FMV on the exercise date and your strike price—is considered an adjustment item for the AMT. While not taxed immediately as ordinary income, this spread is included in your income when calculating the AMT. Your AMT cost basis is higher than your regular tax basis. It is calculated as your regular tax basis (shares x strike price) plus the total bargain element.
Consider an example where you exercise 100 ISOs at a strike price of $10 when the FMV is $70. Your regular tax cost basis is $1,000 (100 shares x $10). The bargain element is $6,000 (($70 FMV – $10 strike price) x 100 shares). Your AMT cost basis is therefore $7,000 ($1,000 regular basis + $6,000 bargain element). This higher basis is used specifically to calculate your gain or loss for AMT purposes if you sell the shares in a future year.
Reporting the Sale on Your Tax Return
The final step is to report the sale accurately on your tax return. You will receive Form 1099-B from your brokerage firm. The cost basis reported by the broker in Box 1e is often incorrect for shares acquired through employee stock options. The broker may report only the strike price paid, omitting the compensation income for NSOs or using the regular tax basis for ISOs.
To correct this, you must use Form 8949, “Sales and Other Dispositions of Capital Assets.” On this form, you detail each stock sale and make adjustments to the information on Form 1099-B. You will transcribe the proceeds from your 1099-B and then enter the incorrect basis from Box 1e into column (e) of Form 8949.
In column (f), you will enter adjustment code “B,” which indicates that the basis reported by the broker is incorrect. In column (g), you will enter the amount of the adjustment, which is the difference between your correctly calculated cost basis and the basis reported on the 1099-B.
Once Form 8949 is completed, the totals are carried over to Schedule D, “Capital Gains and Losses.” Schedule D consolidates the information from Form 8949 to compute your total short-term and long-term capital gains and losses for the year. This final figure from Schedule D is then reported on your main Form 1040 tax return.