Change in Form 1099-B Cost Basis Reporting Can Result in Double-Counting of Income

Prior to 2014, the cost basis of stock acquired through compensatory stock options was reported to the IRS by most brokerages on Form 1099-B, Proceeds From Broker and Barter Exchange Transactions, as the sum of the employee purchase price plus the compensation component reported on Form W-2, Wage and Tax Statement. Although this method was optional, most brokers provided this information. With the issuance of final regulations (T.D. 9616), beginning in 2014, brokers are prohibited from adding the compensation component to the employee cost, thereby understating the total cost and overstating the gain on the sale of the stock on Form 1099-B.

The final regulations mostly cover more complex reporting issues related to debt instruments; it is somewhat surprising that reporting compensatory options is even addressed. Most of the comments the IRS received about the proposed regulations (REG-102988-11) did not even mention the compensatory stock option reporting issue, but behind the scenes a battle was brewing.

Compensatory stock options are a very small part of the reporting compliance requirements brokers face. At the time these proposed regulations were issued in 2011, compliance with the Foreign Account Tax Compliance Act, P.L. 111-147, was costing the financial community millions of dollars in software revisions. The industry had just come through the mandatory basis reporting overhaul and was feeling overburdened by all the changes.

The proposed regulations retained optional reporting of the compensatory portion of the cost basis by brokers, with the only hint of a contemplated change being a note that the IRS was "exploring the possibility of adding an indicator on the Form 1099-B to denote a sale of compensation-related stock" (preamble, Explanation of the Provisions, available at www.regulations.gov). The IRS also wanted to add a checkbox to the transfer report that companies provide to brokers when stock options are exercised.

Inconsistency in reporting practices among brokers and resulting taxpayer confusion was highlighted by commenters who urged that the compensation portion not be included in the reported cost basis. In a comment letter to the IRS, Wolters Kluwer Financial Services argued that "elimination of the requirement to track compensatory options for transfers would not unduly affect taxpayers, who are well positioned to adjust their basis on Form 8949 [Sales and Other Dispositions of Capital Assets] for income recognized" (available at www.regulations.gov). The IRS acquiesced to the financial community and in the final regulations pronounced that brokers would no longer be allowed to report the adjusted basis.

The change in broker reporting came as a surprise to many tax preparers. Since the compensatory income is already included in the employee's Form W-2, the failure to report it in the Form 1099-B cost basis results in double-counting the income unless an adjustment is entered on Form 8949.

In many cases, the compensatory income is small and its omission would be hardly noticeable, but the reporting as a covered transaction is potentially even more likely to lead to errors by taxpayers and preparers alike. Many taxpayers falsely assume that the cost basis provided by brokers in covered transactions has somehow been vetted by the broker. Brokers do their best to provide correct information, but responsibility for accurately reporting basis still resides with the taxpayer. As demonstrated by basis reporting for sales of partnership interests, the original cost has not and could not have been adjusted by the broker for partnership income, deductions, and distributions from subsequent Schedules K-1, since that K-1 information is not readily available to the broker.

Some brokers, such as E-Trade, proactively provided customers with supporting information that correctly computes the gain or loss. But many clients of the author's firm did not initially provide this information because it was not included with their Forms 1099-B. Clues to this potentially double-counted income are unusually large short-term gains from sales of employer (or former employer) stock or having income reported on Form W-2 with Code V, "Income from exercise of nonstatutory stock option(s)." If W-2, box 1, taxable wages are higher than Medicare wages in box 5, this indicates that a disqualifying sale of stock acquired through incentive stock options may have occurred and the Form 1099-B basis will also be underreported.

To help determine if the basis is understated, many tax software providers offer the ability to search by keyword or input box for Code V or short-term gains in excess of some specific dollar amount to pinpoint any affected clients.

The potential is huge for errors in future years, when stock acquired in a prior year is sold. The basis in the broker's records will not reflect the additional compensatory income from a prior-year W-2. It will be difficult to recognize the omission, and the necessary information may be hard for the client to obtain from a former employer or even a current employer.

That the presence of large taxpayer-favorable adjustments on Form 8949 could also cause undue IRS scrutiny of the return is also a concern. This would be a waste of the Service's resources as well as an unnecessary burden on taxpayers and preparers. Reporting an incorrect cost basis also seems to undermine the original intent of basis reporting by brokers.

One solution is to have the client provide the broker with a revised cost basis for shares remaining after each transaction or at the end of the year. The preparer or the client can also track the transactions as they occur. Preparers can ask clients who exercise options to provide the transaction advices as the exercises occur. This information should be retained to catch any omitted basis in future years. The best solution, however, would be for the IRS to reconsider the prohibition against broker reporting of compensatory option income and return to the widely used practice of reporting the entire cost basis on Form 1099-B.