It’s tax season again and that means gathering up all your tax-related documents and giving them to your tax preparer or piling them in the corner of your desk at home awaiting TurboTax Weekend.
Whichever approach you take for this yearly task, if you sold shares from a restricted stock unit (RSU) grant that vested last year or in a previous year, there is a common income tax reporting mistake you need to be aware of. We see this issue come up nearly every year, and there’s no reason to think this year will be any different. It has to do with how RSU share sales are reported to you, and in turn how you or your tax preparer reports them on your tax return. If you’re not careful, you may wind up paying tax twice on the same sale.
Before we dive into the specifics, first let’s go through a quick refresher on the income taxation of RSUs.
Taxation on RSUs happens in two parts—when you receive the shares and later when you sell them.
There is no tax owed when you receive an RSU grant that is subject to vesting. When your RSUs vest, the company exchanges your RSUs for actual shares in the company stock and places those shares in a brokerage account for you. At that point, the market value of the shares you receive is taxable to you as ordinary income. The RSU income is reported on your pay stub when you receive the shares, along with your normal salary and bonus income, and it’s reported again at year-end on your Form W-2.
Just like your regular salary income, RSU income is subject to payroll taxes, including Social Security and Medicare taxes, and any state and local payroll taxes as well. The company is required to withhold income tax and payroll tax on this income, and it does so by either withholding or selling enough shares to pay the tax (which can be problematic for private companies). This is the first part of RSU taxation.
Now, for the second part. When you receive RSU shares, your “cost basis” in those shares is their market value on the day you received them. Cost basis is the tax accounting method used to keep track of the value of shares you’ve already paid tax on in part one above, and it’s used to calculate gain or loss on shares when you later sell them. If the stock price goes up from the day you received your shares, you will have a taxable gain. If stock price goes down, you will have a loss.
For example, let’s say you receive 1,000 shares on March 1, and the stock price is $10 per share. The value of those shares—$10,000—would then be taxable to you as ordinary income, which means your shares have a cost basis of $10,000. You decide to sell the shares on April 1 when the stock price is $12 per share. The value of your shares when you sell them is $12,000, and since you have a cost basis of $10,000, your gain is $2,000. You then owe tax on the $2,000 gain in addition to the tax on the ordinary income from receiving the RSU shares when they vested.
Here’s where the problem comes in that you should be aware of come tax season. At year-end, the brokerage firm that executed the trades to sell your shares reports the sales to you on Form 1099-B. There is a space on Form 1099-B to report the cost basis of the shares you sold in box 1e. Ideally, the number in this box would be your true cost basis—the market value of the shares on the day you received them, as described above. However, brokerage firms often report $0 in box 1e on Form 1099-B. If you or your tax preparer doesn’t notice this, you may pay tax twice on your sales.
This is how that might happen. Let’s say you didn’t notice that Form 1099-B box 1e had a value of $0 instead of your true cost basis of $10,000. On your tax returns you would report the sale of your shares on April 1 for $12,000 with a cost basis of $0, resulting in a taxable gain of $12,000, instead of the correct $2,000 figure. Instead of paying tax on ordinary income of $10,000 and capital gain income of $2,000, you would mistakenly pay tax on $10,000 of ordinary income and $12,000 of capital gain. You would be paying tax twice on the income from receiving RSU shares—and that’s paying tax on an extra $10,000 of gain!
One additional note to be aware of: The tax you pay on the sale of your shares follows the normal rules for gains and losses on investments. If you hold the shares for one year or more, any gain is taxed at the favorable long-term capital gains tax rates. If you hold the shares for less than one year, as is the case above for the shares sold on April 1, any gain will be taxed at short-term capital gains tax rates, which are the same as ordinary income tax rates. Notice that the gain is equal to $0 on the day you receive the shares, and you’ve already paid all the tax you owe up to that point. There is no tax advantage to holding the shares.
Being aware of these factors is essential, and preparing a tax projection during the year can help avoid costly errors on your tax returns at year-end. Whether you’re having a professional prepare your tax returns or doing them yourself, be sure to check for this common tax reporting error with RSUs.
Parkworth Wealth Management provides holistic wealth management services including financial planning, equity compensation planning, investment management, tax planning, and others, on a fee-only basis and as a fiduciary, acting in clients’ best interests. If you want to understand how ongoing tax planning and equity compensation planning can help you build net worth and avoid tax reporting mistakes, schedule a complimentary consultation.
