At a glance

Exercising stock options can create ordinary income, an adjustment for alternative minimum tax (AMT), and later capital gain or loss when you sell the shares. How you report the exercise depends on the option type (NSO vs ISO), whether your employer withheld taxes, and whether you met ISO holding period rules. Reliable documentation—W-2, Form 3921 (for ISOs), and Form 1099-B—makes accurate reporting possible.

Why correct reporting matters

Failing to report option exercises correctly can trigger underpayment penalties, interest, or audits. In my work advising clients, the most common costly mistake is treating ISOs like NSOs or ignoring AMT triggers when exercising large ISO blocks during a run-up in stock price.

Authoritative IRS guidance: see Publication 525 (Taxable and Nontaxable Income) and Publication 550 (Investment Income and Expenses) for general rules, and Form 6251 instructions for AMT specifics (IRS.gov).

Which forms and lines matter?

  • W-2: NSO bargain element (spread at exercise) usually appears in Box 1 (wages), Box 2 (federal income tax withheld) and may show Social Security/Medicare withholding; employer payroll reporting matters.
  • Form 3921: Provided for ISO exercises showing date of grant, exercise date, exercise price, and FMV at exercise. This is informational and helps compute AMT adjustments and basis upon sale.
  • Form 1099-B: Broker report for sales of shares; required to complete Form 8949 and Schedule D.
  • Form 8949 and Schedule D: Report sales of shares (capital gains/losses) and adjust basis for amounts already taxed.
  • Form 6251 (AMT): Report ISO spread as an adjustment in the year of exercise when AMT rules apply.

Step-by-step: Reporting Non‑Qualified Stock Options (NSOs)

  1. Identify the bargain element at exercise: (FMV at exercise − strike price) × shares.
  2. Confirm employer reporting: the bargain element should be included in your W-2 wages for the year of exercise (see IRS Pub. 525).
  3. Report ordinary income: the amount included on your W-2 is reported on Form 1040 as wages. If your employer omitted withholding, you still must report and pay taxes.
  4. Establish basis for sale: your cost basis in the shares becomes strike price + amount already taxed as compensation (the bargain element). Track adjusted basis carefully.
  5. Later sale: when you sell the shares, report the sale on Form 8949 using the cost basis above. Transfer totals to Schedule D. If you sell immediately, the capital gain/loss is usually minimal since basis reflects recognized income.

Example (NSO): You exercise 1,000 NSOs with strike price $15 when FMV is $30. Bargain element = (30 − 15) × 1,000 = $15,000. That $15,000 should appear on your W-2 as wages and is taxed at ordinary rates. Your basis if you keep the shares becomes $15,000 (bargain element taxed) + $15,000 (strike paid) = $30,000 total basis.

Step-by-step: Reporting Incentive Stock Options (ISOs)

ISOs are handled differently:

  1. No regular wage income on exercise generally: ISO exercises do not create ordinary income reported on Form 1040 in the year of exercise unless you make a disqualifying disposition.
  2. AMT adjustment: the ISO bargain element (FMV at exercise − strike price) is an adjustment for AMT in the year you exercise. Use Form 6251 to see if AMT applies (IRS Pub. 525; Form 6251 instructions).
  3. Holding periods and sale taxation:
  • Qualified disposition: To get favorable long‑term capital gains on the entire gain, you must hold the shares at least 2 years from grant and 1 year from exercise. If satisfied, the gain on sale (sale price − strike price) is taxed as long‑term capital gain; the bargain element is not taxed as ordinary income, though it may have been an AMT preference previously.
  • Disqualifying disposition: If you sell before meeting holding periods, the bargain element is treated as ordinary income in the year of sale (often reported by employer on your W-2), and remaining gain (if any) is capital gain.
  1. Reporting at sale: report sale on Form 8949 and Schedule D. If you previously paid AMT on the ISO spread in year of exercise, you may be eligible for an AMT credit in later years (Form 8801) when the ISO gain is taxed as regular income or if AMT no longer applies.

Example (ISO): You exercise 1,000 ISOs with strike $5 when FMV is $50. ISO spread = (50 − 5) × 1,000 = $45,000. You do not report this as regular income in year of exercise, but add $45,000 to AMT income on Form 6251 which may increase AMT owed that year. If you sell after meeting holding periods and buyers’ market price is $80, the taxable long-term gain is (80 − 5) × 1,000 = $75,000 taxed at capital gains rates.

Common mistakes I see in practice

  • Treating ISOs like NSOs and paying incorrect taxes or missing AMT triggers.
  • Forgetting to adjust basis on Form 8949 when W-2 already included NSO income, which can double-tax the same amount as ordinary income and capital gain.
  • Losing Form 3921 or ignoring broker 1099-B details, which complicates year-of-sale reporting.
  • Misunderstanding withholding: employers commonly withhold for NSO exercises but often do not withhold enough for large bargain elements; estimated tax payments or increased withholding may be necessary.

Practical recordkeeping checklist

  • Save W-2s showing option income.
  • Keep Form 3921 (ISOs) and Form 1099-B (sales).
  • Track grant date, grant price (strike), exercise date, exercise price, FMV at exercise, and sale date and price.
  • Maintain a running worksheet of adjusted basis calculations.

Year‑end and planning strategies

Example: Complete reporting workflow (NSO followed by sale)

  1. Exercise 1,000 NSOs: strike $15, FMV $30 → bargain element $15,000.
  2. Employer reports $15,000 on W-2 Box 1 and withholds payroll taxes (if applicable).
  3. Basis in shares = $15,000 (bargain element taxed) + $15,000 (cash paid) = $30,000.
  4. Year later sell all shares at $40, receive 1099‑B reporting gross proceeds $40,000. On Form 8949, report sale with basis $30,000; capital gain = $10,000.
  5. Transfer totals to Schedule D and include on Form 1040.

When to get professional help

If you: exercise large blocks of ISOs (big AMT risk), hold concentrated positions causing material portfolio risk, or receive confusing tax documents (missing 3921/1099‑B or W‑2 treatment unclear), consult a CPA or tax advisor early. In my experience, proactive coordination between payroll, brokerage, and tax advisor avoids costly late-year surprises.

Quick reference: Actions on common forms

  • Form 1040: Report wages (NSO bargain element if on W-2) and capital gains net from Schedule D.
  • Form 8949/Schedule D: Report sales of shares. Adjust basis where compensation already taxed.
  • Form 6251: Include ISO spread as AMT adjustment in year of exercise, if applicable.
  • Form 3921: Use for accuracy and AMT support; keep for your records.

Sources and further reading

Professional disclaimer: This article is educational and does not replace personalized tax advice. Rules for stock options and AMT are complex and fact‑specific; consult a qualified tax professional for guidance tailored to your situation.

If you want, I can prepare a fill-in worksheet (spreadsheet format) to calculate bargain element, basis, and expected AMT impact for a specific exercise scenario.