IRS wants taxes on my non-qualified stock option sale.

February 27, 2006 8:41 AM

I cashed in some stock options and forgot to tell the IRS, now they want $9,401. I don't think I owe them that much.....

So I changed jobs last Christmas time (late 2k4.) I had some options from my old company (large orange stores) and did a cashless sell on 12-24-04. Since I am not a big timer I made a profit of about $3,000.

I did make a mistake, I was absolutely sure I sold that stock in 2005, so I did not count the income in my 2004 taxes. Obviously I was drinking too much eggnog and got the date wrong. So now the IRS has sent me a letter demanding I pay them an extra $9,401 in taxes for 2004 as a result of the stock sale.

All the options I cashed in were non-qualified (which I understood that the taxes were taken out up front.) The IRS says the brokerage firm reported I made $35,000 from the sale of these options (and I reported none, so that is why the IRS is angry.) Trouble is the $35,000 was the actual sale price of the stock I sold, not the profit I made (about $3,000 remember.) I have documentation from the brokerage firm listing total sale price and my total profit (minus the taxes they said they paid.)

Obviously I haven't investigated this as much as I should. This was my 1st time having any type of capital gains. So my questions:
1. With whom do I start to get this all cleared up? IRS or the brokerage firm?
2. I didn't even make $9000 on the sale of the stock, it can be possible I owe that much in taxes, can it?
3. Why would the brokerage firm report to the IRS that I made all that profit ($35,000)? With non-qualified options where they withhold the taxes shouldn't they only report to the IRS what my profit was (which would increase my taxable income.)? Have they made a mistake also or am I just not understanding the process?
4. I did under report my taxable income for 2004, am I looking at a HUGE penalty from the IRS standpoint?

I know some answers will be 'get thy to an accountant' which I will be doing, but I just got this letter over the weekend and I want to get my hands around how much trouble I am in so I can sleep a bit better.

posted by elastic.scorn to work & money (8 comments total)

The forms that the brokerage firm files don't have the cost on them, just the sale amount. So the IRS assumes the worst, that you got the shares for free.
posted by smackfu at 8:45 AM on February 27, 2006

Same-day sale of stock options basically counts as regular income, not capital gains. Since you have docs from the brokerage that are apparently correct, just ignore the IRS's apparently-wrong letter. (Studies show that very many of the threat letters that the IRS sends out are wrong.)

You need to file a 1040-X (Amended) for 2004. Include the PROFIT from the stock option sale as income, as your documents show. Include a photocopy of the documents. This will increase the amount of tax owed by $3000 * your marginal tax rate. Include a check for that amount when you file the amended return. Don't include any additional amount for penalties - the IRS will let you know. Underpayment penalties might be as high as 20% of the underpaid tax, but are generally waived for small underpayments.

You'll also need to file an amended state return.

You should do this quickly, don't sit on it forever. If the IRS machine thinks you are ignoring it, wheels will be set in motion that you may not like. If however you respond quickly with an amended return, that will essentially reset the terms of the debate between you and they, and any future correspondence from them will have to address why your form 1040X is wrong, if it is. See what I'm saying?
posted by jellicle at 9:01 AM on February 27, 2006

Yes you need an accountant and at this point, probably a tax lawyer.

From my (cursory) understanding of stock options, you have 2 portions of income to worry about: 1) the difference between the strike price and the market price at the time you exercised your options, and 2) any gain between that point and the sale date.

It sounds like you exercised the options and immediately sold the shares; if so, I have bad news for you: #1 above, the amount of the sale minus the strike price, is all ordinary income and does not qualify for long-term capital gain treatment (and more bad news, you do not have any, or at most minimal, #2 gain which may qualify for capital treatment). So yes, you are probably in trouble for not paying in the proper year, and yes, you probably owe 25-30% of the difference between strike and sale, depending on your tax bracket.

Call a lawyer!
posted by rkent at 9:03 AM on February 27, 2006

The form 1040X is not any more difficult than any other tax form. If you normally do your own taxes, you can do the 1040X, and consider the time spent to be your unofficial penalty for sloppiness. You did keep a copy of the 1040 you filed, right? That will make things much quicker. If you have your old 1040 and all the new forms needed (see IRS website) it's about a 30-minute process to fill out the 1040X.

If you normally don't do your own taxes, well, take this info to whoever did your 2004 taxes and have them do the 1040X. Duh. Simple.

You don't need a tax lawyer. Nothing here is a legal question.
posted by jellicle at 9:14 AM on February 27, 2006

Thanks jellicle, you speak with authority. For my sake I hope you aren't a landscape engineer. I did my own taxes on the internets (turbotax I think.) I do have my 2k4 returns somewhere. I will get professional accounting advice before I do anything, but my girl will be happy to know her engagement ring money will not have to be sent to the IRS because of my mistake.
posted by elastic.scorn at 9:31 AM on February 27, 2006

Seconded jellicle (I am a tax pro, but I am not a tax lawyer, nor am I your tax pro).

This is a fairly common situiation. (not this per se, but forgetting things and getting a terrifying letter from the IRS) Keep the letter. File the 1040X, which is easy for anyone who does their own taxes. It will ask if this is being filed in response to a letter from the irs, indicate that it is. Include a copy of the IRS letter and a copy of the documents that show your actual profit from the stock sale. Don't send originals (normally you don't need to send the irs any documentation for stocks, but in a case like this it certanly couldn't hurt).

Reply to the letter, telling them you have filed an ammended return. Include a copy of the 1040x, write "copy" across the top. Also include copies of the stock documents.

Expect to pay taxes on the profit, and a pentalty as well.

(also, FYI, qualified vs. non-qualified is in refrence to when they were purchased and if they are able to be taxed at the new maximum 15% rate for capital gains, it doesn't have anything to do with if taxes are taken out or not)
posted by Kellydamnit at 10:32 AM on February 27, 2006

Last thought: make sure to file the 2004 1040X, not 2005. All 2004 matters go on 2004 forms, all 2005 matters go on 2005 forms, and never the twain shall meet.
posted by jellicle at 11:33 AM on February 27, 2006

I'm not an accountant. This is anecdotal.

"Trouble is the $35,000 was the actual sale price of the stock I sold, not the profit I made (about $3,000 remember.)"

I don't need to read anyone else's answers because I had the same sort of problem for 2000 and 2001, except the numbers involved were much, much higher.

And the funny thing is, both years were actually capital losses. So after the IRS initially wanted 80K or something from me, I ended up getting a refund. And for 2001, I owed nothing at all, but they charged me for the lean they filed that I didn't deserve. $42.

Here's the answers to your questions:

1. With whom do I start to get this all cleared up? IRS or the brokerage firm?

The IRS.

2. I didn't even make $9000 on the sale of the stock, it can be possible I owe that much in taxes, can it?

and

3. Why would the brokerage firm report to the IRS that I made all that profit ($35,000)? With non-qualified options where they withhold the taxes shouldn't they only report to the IRS what my profit was (which would increase my taxable income.)? Have they made a mistake also or am I just not understanding the process?

You don't owe that much in taxes. But all the IRS sees is the proceeds of a securities transaction. They don't see the purchase. And so, if you don't file or don't include something like this, they'll just basically assume the proceeds from a sale is one huge capital gain. Which it never will be, of course, but I guess it's the maximal case and they adjust downard from there.

However, the profit from those non-qualified options are probably not a capital gain or loss, they are wage income.

Exercised options like these, especially when you flip them with a "cashless transaction" (which the IRS is no longer allowing, I've heard), are just like your employer paying you your salary. The "wage" amount is the difference between the option price and the market price when you exercise, not sell. In your case, though, the buy and sell market prices are going to be the same or very close to the same, and the difference between your option price and your buy price is that $3,000.

Be very glad that you flipped them like this, because, as happened to me and many others, I held them and had to pay income tax on an amount that for all practical purposes I had never realized because the stock fell a huge amount by the time I did sell it. Lots of folks when bankrupt because of this, actually.

"4. I did under report my taxable income for 2004, am I looking at a HUGE penalty from the IRS standpoint?"

You necessarily did, since this is taxable income, not a capital gain. It's another $3,000 in wages. You'll add it to your wage income. Your W-2 probably didn't include it, but some employers, when they're aware of this transaction, will report it as wage income.

So, given what you've said, what you're looking at is that you owe the IRS another amount of income tax on that 3K and on the other amount you say you didn't report to the IRS as taxable income. Depending on what bracket you are/were in, that's not going to be a lot of money. Certainly not what they're calculating based off of that 35K figure. (Keep in mind that they're guessing the proceeds were a capital transaction and not wage income—they have no way of knowing, independently, that these were options you exercised and sold.)

You'll need to file an amended return reflecting the above changes, and since you're going to owe something, they're going to calculate an interest rate and penalty for that amount. You'll need documentation of your option price, and your buy and sell prices.

(Actually, if there's any difference between the buy and sell price—not likely to be significant because of you flipping them—then that difference will amount to a capital gain or loss. Also, BTW, if you traded other of that same stock that year, be aware that unless you specifically asked the broker to sell a specific block of stocks that you had previously bought, then the rule is basically FIFO.)

Call the IRS—I found them surprisingly helpful. They know that the 35K number is something they basically pulled from their ass. They want you to report it correctly.

If someone bought and sold the same $1 stock every day—that is, one share at $1 and it never changed—then your broker would report $365 dollars in proceeds, even though what that actually is is a break-even.
posted by Ethereal Bligh at 11:55 AM on February 27, 2006