When you sell stock that you purchased by exercising an option granted under an employee stock purchase plan, you must report your profit (or loss). The tax consequences depend upon your holding period, which is defined as:
Whether the option price was below the stock’s fair market value at the time the option was granted
How long you held the stock after you exercised the option
How long after the option was granted that you sold the stock
If the price you paid for the stock was less than its fair market value on the day the option was granted, you must report the difference as W-2 income. Your employer should include this amount in your total earnings on your Form W-2.
If either of these statements apply to your sale:
You held the stock that you purchased when you exercised the option for 1 year or less, or
You held the stock for less than 2 years after the option was granted to you,
Then the difference between the fair market value on the day you exercised the option and the option price is W-2 income. Your employer should include that amount on your W-2. When computing the capital gain or loss on the sale of your stock, use as your basis the fair market value on the date you exercised the option.
If both of the following statements apply to your sale:
You held the stock for more than 1 year, and
You held the stock for 2 or more years after the option was purchased in the plan,
Then part of the capital gain is W-2 income, but if there’s a loss, then nothing is included in W-2 income. Your employer will make sure that the income is properly reported on your W-2 form.
If the price you sell the stock for is more than the amount you paid for the shares (the option price), then you have a gain on the sale. You'll use the fair market value on the date you exercised the option as your basis.
If the price you sell the stock for is less than the option price, then you don’t have any W-2 income. Your basis is the option price.
To avoid being taxed twice on this income, make sure you include the wage income that your employer reported on your W-2 in the cost (or basis) of the stock. Report your stock sales in the Sale of Stocks, Bonds, Mutual Funds, and Investment Property section of the Interview.
For more information, see IRS Publication 525: Taxable and Nontaxable Income.