Taxation of RSUs explained
This type of income is commonly seen on W2s of our clients in San Francisco, and increasing in New York, Chicago, Los Angeles, Boston, Austin, and other cities where we have a large client base. Because of our extensive experience with these types of clients, we have seen many variations and scenarios of how the tax effects ultimately are shown on your return. We will attempt to summarize some of these below. Please feel free to leave comments with questions & we will be happy to address.
Q: Will I get double-taxed on my RSUs?
A: You do not get double-taxed on RSUs, although taxation may occur at more than one point in time. The general mechanics of RSU compensation are this:
- You are granted RSUs and they vest in a given year. In that year, you will see them show up on box 14 of your W2 with a code of “RSU.” You may also see equity compensation show up on box 12 of your W2 as code V.
- At the time that these RSUs are received by the taxpayer, part of them are actually sold to offset the tax withholdings, and some tax withholdings are paid using the proceeds. In states like California, where there is a state tax on earned income, part of the shares is sold for federal withholdings and part is sold as state withholdings
- The total amount of RSUs will show up as a component of your total wages on your W2. You may wonder “why is this W2 income and not showing up as a capital gains/loss item?” Well, it was given to you as compensation for services performed, and the employer shows it as such. It is a deduction to the employer that way and conveniently allows the IRS to know exactly how much you earned.
- These remaining RSUs are now yours to sell, and many choose to sell them all right away. This part, however, shows up on your 1099 from the broker that is being used for the transactions. Let’s say it is Etrade for sake of this discussion. We will use $1,000,000 as an even number for the amount you sold, and $990,000 as the Fair Market Value (FMV) at the time of the grant.
- You receive your Etrade statement and see the total sale price of $1 million in proceeds. However, you do not see your cost basis. The cost basis is also the amount of share compensation you were already taxed on at the time these shares were granted. There are several ways that this is calculated – it may be the box 12 amount mentioned earlier or the box 14 amount. Some other types of equity compensation may also justify form 3922 or 3921 to be provided by the employer.
- If you use the standard brokerage statement import on most tax software, you may end up with this basis of zero, causing you to owe tax on the full $1 million at short term (ordinary) rates, which are currently 37% on the federal side, without taking into account the amount you were already taxed on at the time of vest. This would, in effect, create a double-tax scenario, which is why it is very important to calculate your basis properly. The amount of capital gains in this example would only be $10k, which is computed by subtracting the basis of $990k from the total sale price of $1 million.
- Why does it say zero on the brokerage statement? This is because your basis in the shares is the Fair Market Value at the time they were granted, which is the amount of income that you were already taxed on at the employer level. The broker may not know this amount, so they put zero as your cost basis.
- Sometimes, the employer will provide data showing how much was granted and the Fair Market Value at the time of the grant
- The basis may be quite a bit harder to calculate the longer the shares are held, as the taxpayer may not have the records necessary to compute basis. Also, the grant date may be hard to discern. However, long-term capital gains are taxed at a more favorable rate than ordinary income, so if you believe in the company, it may make more sense to hold onto the shares for longer than one year after the grant.
- This brings me to another point: long-term vs. short term gains. Long-term are capital items (like RSUs) that are held for more than one year after they were granted/obtained. This rate is 23.8% (20% plus the 3.8 tax on net investment income for high-earning taxpayers). On the other hand, the rate for short term gains is the same as that for earned income, which is 37% for high-income taxpayers. With this in mind, it may make more sense to hold onto these investments from a tax perspective if you truly believe in the company. However, this is an investment and tax/life planning decision that one should make on their own.
- The takeaway here is that you must calculate and report your basis in order to avoid double-paying Federal and State (if applicable) taxes.
Q: What happens if I am granted stock options when the Fair Market Value is at a market high and I am taxed on them, only to have the value drop prior to me selling these shares on the open market?
A: This turns into regular income at the time of grant and a capital loss at the time of sale. To put this in form language, this results in income on the W2 and a loss on the 1099-B. I have seen this in instances prior to a buyout or other event that temporarily inflates the stock price at the time that shares are granted. Then, some time later, the taxpayer chooses to sell the shares, leading to a short term capital loss. If the loss is high, the taxpayer may not have enough capital gains income to offset the loss and can only use $3000 of it on their tax returns each year and carry forward the remainder.
Q: I did not report my RSU income and received a CP2000 letter. What do I do?
A: This is extremely common. A CP2000 letter is a letter of adjustment that the IRS gives to taxpayers when items are missing from their return. This commonly happens when a taxpayer is missing 1099 information, such as 1099-B Brokerage statements.
Taxpayers are told by their company at the time that shares are granted that part of the shares are sold to offset taxes. Some may shrug this off and think to themselves that the tax end of things has already been taken care of by the firm. They complete the return on their own on TurboTax using the W2 only and don’t bother looking for anything on the brokerage side under the erroneous belief that anything tax-related for the shares has already been reported accordingly on the 1099. Four months later a letter comes in the mail with a large tax bill – usually the tax bill is the actual amount of the share sale price, regardless of the basis. From our prior example, the tax assessed would be based on $1 million of income, rather than the $10k of actual capital gains that occurred. Clearly this amount is far more than one would expect. This is when our practice gets calls from taxpayers receiving such a notice – they normally say the same thing: “The IRS is trying to tax me on money that was already taxed. My employer already sold shares to cover this tax, so I do not understand why the IRS is asking for tax on this again.”
The reason is because of the basis reporting. Earlier in this article I mentioned that the brokerage will report zero as the cost basis in many cases where RSUs are sold. Well, the taxpayer is not the only party that receives this 1099 with no basis reported. The IRS also receives the same document. Without having a basis number, they simply assess the tax, plus interest and penalties, on the full amount of the stock sold, not knowing how much was already included in your W2 and taxed as regular compensation.
The solution to this issue that we offer at our firm involves re-computing the amount of schedule D gains and losses, asking the client for relevant information to substantiate the basis, possibly amending the return with “CP 2000” specified at the top as per IRS instruction, and writing a letter of explanation on behalf of the taxpayer showing documents to explain the basis and asking for an adjustment to their adjustment. The taxpayer may have to write a check for a balance (and in some cases where the share price dropped, may even be entitled to a refund).