Correcting Cost Basis of Shares from NSOs Post-IPO

Strategy Overview

When you sell shares, you recognize either a gain or loss --> calculated as the selling price minus the purchase price (also know as cost basis). In nearly all cases this is really simple and that's that. But due to a few (annoying) quirks, shares acquired via exercising an NSO when the company was still private (i.e. pre-IPO) very frequently have an inaccurate cost basis relative to your tax basis (which is what you care about). This isn't an error; the broker is doing what they are technically suppose/required to do. But it can cause an individual to make incorrect tax decisions, and/or report an incorrect amount of gain/losses on their tax return if it isn't corrected.

Tax Details

Your cost basis technically means the price you purchased shares at. For example, if you purchase 100 shares of MSFT at $300 per share, your cost basis would be $300 per share (captain obvious strikes again!). But what if you purchased 100 shares via an NSO with a strike price of $1 when the FMV is $5?

• Per NSO taxation rules, you will (1) pay $1 per share to buy the shares, (2) owe income tax of $4 per share ($5-$1), and thereafter the shares will have a $5 per share tax/cost basis

• But you "technically" bought the share(s) for $1

• Post-IPO when your shares are transferred to a broker, the brokerage firm is required to use/list the "technical" cost basis of $1 per share instead of your tax/cost basis of $5 per share

The Fix Is Relatively Simple (Though VERY Frequently Messed Up):

• First and foremost, be keenly aware that this is occurring. Most individuals aren't aware that this happens; they simply think their tax basis ported over and all is good. This oversight will result in an incorrect tax calculation (and very likely you overpaying taxes).

• Inform your CPA when you sell these share so that she/he update the tax basis to correct amount. In the year(s) you sell the exercised NSO shares, inform your tax preparer + provide them with your exercise confirmations. Your tax preparer will fill out a "cost basis adjustment" on your tax return to correct the cost basis (i.e. in the example above, from $1/share to $5/share).

Key Considerations/Flags/Strategy

These sections are not applicable for this tax "strategy". Ensuring that you utilize the correct cost basis for your NSOs is ensuring you file your taxes correctly -> which is something we always recommend you do.

Example