@roger-vw wrote:
I thought it would be inheritance since it belonged solely to her.
So no I didn't.
Not sure what stepped up basis is ?
There are two issues here.
First is "basis". Basis is, roughly speaking, the amount of after-tax dollars that are invested in something. When you buy a stock for, lets say $100, $100 is your basis. If you sell for $150, your capital gain is the selling price minus basis. So your gain is $50, and that's what you pay tax on, because you already paid tax on the basis.
When you inherit property, including stocks, you receive a "stepped up" basis, equal to the fair market value on the date the previous owner died. So let's suppose your spouse purchased the stock for $100, and it was worth $150 on the day they died in 2021. That is your new basis. However, suppose you sell the stock in 2022 for $175. That's not all tax-free inheritance, only the basis is tax-free. The gain (increase in value) since their death is taxable income to you. So you would report that as sale of stock with a selling price of $175 and a basis of $150, so $25 is taxable to you. On the other hand, if the stock was sold the day she died for $150, and the money was held in escrow while legal work was done, then you have to report the sale on your 2021 tax return because the money was yours even though you hadn't received it yet. The sale was $150 and the basis was $150, so no gain and no tax is owed.
The IRS is assuming the entire proceeds are taxable because you did not report the sale correctly.
However, the second issue is, what is the basis of the options? Generally, the basis of a stock option is whatever the employee paid income tax on. Depending on the type of option, this might be zero or it might be something. For example, suppose she received an option to buy 1 share at $100. That should be taxable income on her W-2, and her basis in the option is $100. Suppose she exercises the option at $150. Even though the market value was $150, her basis is still $100, what she paid. If she sells right away, she has a $50 taxable gain.
I can't find anything that confirms whether or not options get a stepped up basis after death. Let's assume they do not. If you exercise your spouse's option to buy 1 share at $100 (when the price is $150) and you immediately sell it for $150, you have a $50 capital gain.
Or, let's assume that options do get a stepped up basis. When your wife dies, the market value of the stock is $150, so her option has a basis of $150. You exercise the option at $175 (buying for $100 and selling for $175). Because her basis was $150, your taxable capital gain is $25.
You may need to see an accountant to determine what the basis of the options was, if you inherited the option instead of actual stock.
You need to reply to the IRS assessment with a detailed letter of explanation, and include an amended return that reports the sale of the stock, the correct basis, and calculates and pays capital gains tax. Tax might or might not be owed depending on the basis of the option, the value of the stock on the day she died, and the price of the stock on the day you sold it. Send the letter and the amended return to the IRS office that sent the notice, not the general address for amended returns. Be sure to respect any deadlines in the letter, because you may lose your right to appeal if you miss a deadline.
Depending on the amount, you may want the assistance of a tax professional to help determine your correct basis.
