What Is Discard Income on a W-2 and How Do I Report It?
Clarify how income from an employee stock sale appears on your W-2. Learn the necessary tax reporting steps to properly adjust your cost basis and file correctly.
Seeing “discard income” on a pay stub or tax document can be confusing, as it is not an official term used by the Internal Revenue Service (IRS). This phrase is an internal payroll or accounting system’s shorthand related to employee stock options. Understanding what this income represents is the first step in ensuring your taxes are filed correctly.
Understanding Discard Income and Stock Options
The term “discard income” is an abbreviation for income arising from a “disqualified disposition” of stock. This situation originates with a specific type of employee stock benefit known as an Incentive Stock Option (ISO). ISOs receive special tax treatment, allowing employees to potentially pay lower capital gains tax rates instead of higher ordinary income tax rates on their profits.
To receive this favorable tax treatment, the IRS imposes specific holding period requirements. An employee must hold the stock for at least two years from the date the option was granted and at least one year from the date they purchased the stock (the exercise date). A sale that meets both of these time requirements is called a “qualifying disposition.”
A “disqualified disposition” occurs when an employee sells their ISO shares before satisfying both holding periods. When this happens, some or all of the profit loses its special tax status and is reclassified as ordinary compensation income, which is subject to regular income tax rates.
Locating Discard Income on Your W-2
When a disqualified disposition occurs, your employer is required to report the resulting compensation on your Form W-2. This income is not listed separately but is included in the total wages reported in Box 1. The amount added is the “bargain element,” which is the difference between the stock’s fair market value on the day you exercised the option and the price you paid for it.
To help clarify the figures, employers will often include an informational note in Box 14 of the W-2. You might see a code like “DISCARD,” “DQDISP,” or “ISO DD,” followed by the amount of income generated from the disqualified disposition. The amount shown in Box 14 is already part of the total in Box 1 and should not be added to your income again.
How to Report Discard Income on Your Tax Return
Reporting the sale of your stock correctly is necessary to avoid double taxation. Along with your W-2, your employer should provide you with Form 3921, Exercise of an Incentive Stock Option. The sale itself is reported on Form 8949, Sales and Other Dispositions of Capital Assets, which then flows to Schedule D.
A primary step in this process is correctly calculating the cost basis of the stock you sold. The cost basis reported by your broker on Form 1099-B will likely only be the exercise price you paid for the shares. If you use this figure, you will pay capital gains tax on the compensation portion that was already taxed as ordinary income through your W-2.
To prevent this, you must adjust the cost basis. The correct cost basis for a disqualified disposition is the exercise price you paid plus the amount of compensation income that was included in Box 1 of your W-2. For instance, if you paid $10 per share to exercise and had $15 per share of compensation income reported on your W-2, your adjusted cost basis is $25 per share.
On Form 8949, you will report the basis from the 1099-B and then enter an adjustment amount in column (g) with code “B” to arrive at the correct, higher basis. This adjustment ensures the “discard income” portion is not taxed a second time as a capital gain.