Cost Basis
The original value of an asset for tax purposes, typically the price paid plus any recognized income, used to calculate capital gains or losses upon sale.
What Is Cost Basis?
Cost basis is the amount the IRS considers you to have "invested" in an asset, used to calculate your capital gain or loss when you sell. For stock acquired through equity compensation, cost basis is not simply what you paid out of pocket — it also includes any amount you recognized as taxable income at the time of acquisition. This distinction is critical because failing to properly account for your cost basis can result in paying taxes twice on the same income.
Capital Gain (or Loss) = Sale Price - Cost Basis
Getting the cost basis right is one of the most common sources of errors on tax returns involving equity compensation.
How Cost Basis Works for Equity Compensation
NSO Exercise
When you exercise non-qualified stock options, the spread (FMV minus exercise price) is taxed as ordinary income. Your cost basis in the resulting shares is the FMV on the exercise date — not just the exercise price you paid.
Cost Basis = Exercise Price + Spread Recognized as Income
Example: Exercise 10,000 NSOs at $2 strike when FMV is $15. The spread is $13 per share, taxed as ordinary income. Your cost basis is $15 per share (not $2). If you later sell at $25, your capital gain is $10 per share, not $23.
ISO Exercise (Qualifying Disposition)
For ISOs sold in a qualifying disposition (held over one year from exercise and two years from grant), your cost basis is simply the exercise price. The entire gain from exercise price to sale price is taxed at long-term capital gains rates.
Cost Basis = Exercise Price
ISO Exercise (Disqualifying Disposition)
For ISOs sold in a disqualifying disposition, the spread at exercise is taxed as ordinary income (similar to an NSO), and your cost basis is adjusted upward to the FMV at exercise.
Cost Basis = Exercise Price + Ordinary Income Recognized
83(b) Election
If you early-exercise and file an 83(b) election, your cost basis is the amount you paid plus any income recognized at the time of the election. If you exercised at FMV (spread = $0), your cost basis equals the exercise price.
RSU Vesting
When RSUs vest, the FMV of the shares on the vesting date is taxed as ordinary income. Your cost basis is that FMV.
Cost Basis = FMV on Vesting Date
ESPP Purchase
Your cost basis for ESPP shares depends on whether the sale is a qualifying or disqualifying disposition. In both cases, the basis starts at the purchase price and is adjusted upward by the amount of ordinary income recognized at sale.
Practical Implications for Startup Employees
Broker Reporting Is Often Wrong
Brokers are required to report cost basis on Form 1099-B, but for equity compensation they frequently get it wrong. The most common error is reporting the exercise price as the cost basis for NSOs, ignoring the income already recognized at exercise. This makes it appear that you have a much larger capital gain than you actually do. You must review and, if necessary, adjust the cost basis on your tax return using Form 8949.
Track Your Basis From Day One
Start tracking your cost basis at the time of each exercise, vest, or purchase. Record the date, number of shares, exercise price, FMV, income recognized, and resulting cost basis per share. This information comes from your exercise confirmations, Form 3921 (ISOs), Form 3922 (ESPPs), and your W-2 (which includes the ordinary income from NSO exercises and RSU vesting).
Multiple Lots and Specific Identification
If you exercise options on multiple dates or receive RSU vests on multiple dates, each batch has a different cost basis and holding period. When you sell, you can choose which specific lot to sell (specific identification method) to optimize your tax outcome. Selling higher-basis lots first reduces your capital gain; selling lots held over one year qualifies for long-term rates.
AMT Basis for ISOs
If you paid AMT on an ISO exercise, your cost basis for AMT purposes is the FMV at exercise (higher than the regular tax basis of the exercise price). When you sell, your AMT gain is smaller, which generates the minimum tax credit recovery. Your tax return must track both the regular tax basis and the AMT basis separately.
How It Relates to Exercising Stock Options
Cost basis is determined at the moment you exercise. The exercise method (cash exercise, cashless, sell-to-cover, net exercise) does not change the per-share cost basis — it only changes how many shares you end up holding. Understanding your cost basis at exercise helps you project your future tax liability at sale, compare the tax impact of holding versus selling immediately, and ensure that your eventual capital gains calculation is correct. Track your cost basis meticulously, and verify it against broker reporting when you sell.