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Welcome to the 22nd edition of the Tech Financial Planning (TFP) newsletter.
As we enter tax season, there’s an easy mistake that can cost tech professionals big time.
The dreaded double tax on their stock compensation.
In this newsletter we’ll break down what the double tax is, how it happens, and how to avoid it.
TL;DR
Cost basis is the original value of your investment, and it’s used to figure out how much you made or lost when you sell
Because of certain IRS regulations, the cost basis for your stock basis is often reported wrong, which means you could pay taxes twice
To make sure you report the right basis, you will need to gather the right documents and forms
A good tax preparer and financial planner can help you avoid the dreaded double tax
What is cost basis and why is it important?
In simple terms, cost basis is the original value of your investment, which you use to calculate how much money you've made (or lost) when you sell it.
Here’s how it’s supposed to work.
You acquire a share of stock for, let’s say, $20 (cost basis)
Later, you sell it for $50.
You have a gain of $30.
Capital loss or gain = Price you sold at - Cost basis.
$30 = $50 - $20
And you would pay taxes on your $30 gain.
For the sake of argument, let’s say your total tax on this gain is 25%.
This means you would pay $7.50 in tax ($30 gain x 25% total tax)
The problem - Cost basis is reported incorrectly
If only it were this simple.
If you sell stock options (ISO or NSO) or RSUs that sale will show up in two places.
Your W2 (reports wages paid and taxes withheld) and the 1099 from the custodian (Etrade, Fidelity, Schwab, etc).
Your 1099-B reports money made (or lost) from selling stocks, bonds, or other investments.
Normally, when you get a 1099, the cost basis is reported correctly and you can mindlessly put that info into tax software.
But the 1099 from the custodian is often very wrong.
Because of certain IRS rules & regulations, the cost basis on the 1099 from the custodian is not accurately reported and often very wrong.
In fact, it’s often reported as $0.
If you don’t catch this then you are overpaying on taxes.
Here’s why
You already paid taxes on the “income” when it was earned (when you exercised your stock options or when your RSUs vested).
So you are paying tax twice on the same income.
It would be like if you paid tax on your salary, but then forgot to tell the IRS you paid taxes, so you paid it again.
Crazy, right?
Let’s go back to our original example from above and see this in practice.
Remember, you paid taxes on a $30 gain.
But if the cost basis was reported incorrectly (cost basis of $0), the IRS would view it as a $50 gain.
Capital loss or gain = Price you sold at - Cost basis.
$50 Gain = $50 (Price you sold at) - $0 (“cost basis”)
That’s an extra $20 of gain.
And instead of $7.50 in tax (remember from above), you would pay $12.50 in tax ($50 “gain” x 25% tax).
An extra $5 in tax (or 50% more tax)!
Yes, $5 may seem small, but let’s use real numbers.
Instead of acquiring $20 worth of stock, you acquire $20,000 worth.
And you sell it for $50,000.
So instead of a $30,000 gain, you are reporting a $50,000 gain.
You are getting taxed on additional $20,000 of income.
With the same situation, you are now paying an extra $5,000 in “double taxation” that you don’t owe!
I don’t know about you, but I certainly don’t want to pay the IRS an extra $5,000.
What To Do
The first thing to do is find the true cost basis.
This can show up in a few places:
A stock supplement form - each custodian has a different name, but this will contain information not reported on your 1099-B…exactly what we need!
On your W-2
Company provided records
Once you have that information, you or your tax preparer will need to adjust the cost basis.
In our example from the beginning, everything remains as-is, except the cost basis will need to be $20 instead of $0.
The capital gain is reduced from $50 down to $30.
And the double tax is eliminated
Quick Note: If you have complexity with your equity comp, I can’t recommend a good tax preparer who specializes in equity comp enough.
The cost of a big mistake (like double tax on your equity) is probably much more than you will pay a good tax person.
Steps we are taking for clients
We have a tax letter we will send out in the coming weeks that will help us highlight important tax planning items - like sales of stock compensation!
If a client has a tax preparer, we will make sure they get a copy of the tax letter so that a) there’s no confusion and b) the cost basis gets reported.
An example section from our tax letter to clients
Last, we will review our client’s tax returns in the spring.
In addition to looking for planning opportunities for 2023, we act as a second set of eyes for our clients.
So if for some reason the cost basis was reported incorrectly, we can catch it and help the client take the appropriate steps to fix it.
Putting It All Together
As a successful tech worker, you already pay a lot in taxes.
You want to make sure you pay the IRS the right amount.
Equity comp is hard, and small mistakes can have big consequences like the dreaded double tax.
If you have significant equity compensation, make sure you have the right team in your corner.
A good financial advisor will help you coordinate the entire process and make sure your tax preparer is aware of all the details.
A good tax preparer well versed in equity comp will make sure everything is reported correctly.
To finish, I’ll leave you with one of my favorite quotes from Steven Jarvis.
“Tip your server, not the IRS.”
Whenever you’re ready, there are 3 ways i can help you
1. Connect with me on LinkedIn, where I post every weekday (unless I’m on vacation). https://www.linkedin.com/in/marshalljoe/
2. Subscribe to the “Tech Financial Planning” newsletter to get equity comp and financial planning strategies in your inbox every Saturday. It’s free: TFP Newsletter
3. Want one on one help? Schedule your Get To Know meeting