W-2 Wages and Stock Options
Have you ever seen the sale of stock on Schedule D with identical purchase and sale dates? At the same time, the sales price is the exact same amount (or close to it) as the cost? This indicates the exercise of stock options by your borrower. As a result, your borrower’s W-2 wages may include “paper” (non-cash) income. It’s important to know how to identify this.
Incentive Stock Options
Companies use stock options to compensate key employees and executives. Incentive stock options (ISOs) are a common form of stock compensation that grant the right to purchase company stock at a discounted price in the future.
When properly executed, ISOs offer significant tax advantages as employees may receive and exercise the ISO without recognizing any gross income. The employee merely records a capital gain when they sell the acquired company stock, which is taxed at a lower rate. Great deal!
However, this preferential tax treatment only applies when an employee meets the specified ISO holding period. When employees do not have patience to hold the stock option for at least two years before exercising, along with meeting additional required criteria, they lose out on the tax benefits. The value of the stock compensation is then included in gross wages on the Form W-2 and taxed at higher ordinary income tax rates.
Incentive Stock Option Example
Let’s say a company grants ISOs worth $10,000 on October 1st to its employee, Sue Barew. Six months later, the company’s stock price soars and Sue really wants to buy a new car. Sue exercises the stock option and sells it on April 1st for $60,000. Sue exercised her ISO too early and does not meet the ISO holding period.
Because Sue did not satisfy the holding period, her Schedule D will report $60,000 for both the sales price and cost of the stock. Her W-2 will then include the actual gain of $50,000 ($60,000 sales price less $10,000 exercise price) in box 1 gross wages. The gain will be included as wages on line 1 of Form 1040 and taxed at higher ordinary income tax rates.
When this occurs, it’s important to not include the gain of $50,000 as W-2 wages for your borrower. This is really “paper” income that’s included as part of salaries on page 1 of Form 1040. Obtaining the W-2 can easily show you how much in salary is actually “paper.” The trigger for identifying this “paper” income in salaries is the specific presentation of the Schedule D as described above. Watch out for this when dealing with executives from companies with stock option plans, especially technology companies.
Want More Detail On This?
The Bukers Academy Online training devotes an entire learning module to this very topic. We’ve included detailed tax return examples to show you exactly what you need to look for on your borrower’s W-2 and tax return to identify actual cash flow from stock compensation.
Curious to see if Bukers Academy Online is a good fit for you and your institution? Please email us at bukers.academy@taxanalysis.com or give us a call at (503) 520-1303.