Foreign Resident and Stock Options

My son is a foreign resident, working for a subsidiary of an American Company. He is working for a year. He bought stock under anon-qualified stock purchase plan that gives options that vest in half a year. He exercised the option when the market price was $2 a share more than his price under the option. Then he kept the stock for three months and sold it at a price $3 more than at which he bought it. I understand that all $5 should be counted as 2006 regular income. Is that right? Also the American stockbroker will be reporting the sale to IRS. Therefore he will have to complete a Schedule D. What is the purchase price that he should put on for that stock so that he need pay no capital gains tax on it, as he should count the profit as ordinary income. His foreign employer does not provide an American W-2.

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I'm going to assume your son is a US citizen and that he is working temporarily out of country (you said he was working for a year). This means he has not changed his tax home from the U.S. and is therefore not eligible for the foreign earned income exclusion. I bring this up because the difference between what he paid for the stock and the FMV on the date of exercise is considered to be earned income and would be part of the formula for excluding earned income. So, given my assumptions, he has a $3 gain per share (paid $2 less than market plus the short term gain of $1 when he sold). He puts $2 per share on Line 7 of his 1040 as that is considered earned income. He adds that $2 to what he actually paid to get his cost basis. Schedule D will reflect $1 per share short-term capital gain.