An employee stock purchase plan (ESPP) is a plan that provides employees with a convenient way to purchase company stock. Often offered via payroll deduction, an ESPP may offer a discount of up to 15% on the company stock, allowing an employee to purchase shares at a cheaper price than what they could have in a typical brokerage account.
Once purchase, the shares accumulate in a non-IRA investment account. Because these are non-IRA, non-tax deferred assets, income taxes are an important consideration for an ESPP. Specifically, special tax rules are applied depending on the holding period for the shares and whether or not the ESPP is qualified or non-qualified. For our purposes, we will focus on a qualified ESPP.
ESPP Tax at Purchase
When you purchase shares of an ESPP, no tax is due and no tax is reported. It is as if you purchased shares on the open market. Even if the shares are purchased at a discount from the current market price, no tax is due. Furthermore, the purchase of shares of an ESPP is not a reportable event for AMT purposes.
That doesn’t mean, however, that information pertaining to the purchase price and the discount applied is irrelevant. In fact, these figures are used in calculating potential compensation income and capital gain income when the shares are sold. When you do sell shares acquired via ESPP, special tax rules dictate what and how much will be reported as compensation income, capital gain, and capital loss (subject to short-term and long-term holding periods).
Tax for a Disqualifying Disposition of ESPP Shares
Like their incentive stock option cousins, an ESPP has special holding period rules that dictate if gains are treated as compensation income or long-term capital gains. Specifically, a qualifying disposition of ESPP shares is anything that meets the following standard:
- The stock must be held for at least 1 year past the original purchase date
- The stock must be held for at least 2 years after the original offer date
Anything that does not meet this criteria is a disqualifying disposition of ESPP shares. From a tax standpoint, a disqualifying disposition of shares means that gains from the discounted price paid at purchase to the price of the stock at the of the offering period is taxed as compensation income. Compensation income is taxed the same as annual wages.
A hypothetical example:
Let’s assume that you purchase shares of stock through an ESPP with a 15% discount. Let’s further assume that the price at the beginning of the offering period is $20 per share and at the end of the offering period, it is $25 per share. In this example, the employee can buy shares of the company at $17 per share, a 15% discount from $20 per share (the lower of the two).
Let’s further assume that the employee later sells the shares (assuming a disqualifying disposition) at $30 per share.
The total gain on this transaction will be $13 per share, or $30 (the final sale price) less $17 (the original price paid). But how is this accounted for?
Because this is a disqualifying disposition, the employee will pay ordinary income tax on the discounted purchase price ($17) to the price of the stock at the end of the offering period ($25), or $8 per share.
This then increases the basis of the stock to $25.
The final sales price ($30 per share) less the cost basis ($25) equals the amount treated as a capital gain ($5). Assuming less than a 1-year holding period, a short-term capital gain is taxed as ordinary income.
The example above illustrates the tax if the share prices increase. However, what happens if the share price goes down after the purchase of the shares? In this scenario, it’s possible that both compensation income and a capital loss will be reportable.
A hypothetical example:
Continuing our example from above, let’s assume that the final sale price of the stock is $15 per share (as compared to $30 per share). In this scenario, the employee will need to report compensation income equal to the discounted purchase price ($17) to the price at the end of the offering period ($25), or $8 per share.
Compensation income increases the cost basis of the stock to $25 per share (as compared to the $17 originally paid). This adjusted cost basis, less the final sale price, will be treated as a capital loss. In our scenario, $25 – $15 = $10 per share.
If you hold the shares longer and they continue to drop in value, you may get hit by overpaying ordinary income tax, while only being able to offset a small capital loss.
Qualifying Disposition of ESPP Shares
If you meet the standard for a qualifying disposition, you will likely report both compensation income and long-term capital gain income. Continuing our hypothetical example from above:
Let’s assume that you purchase shares of stock through an ESPP with a 15% discount. Let’s further assume that you buy shares at $20 per share. In this example, the employee buys shares of the company at $17 per share.
Let’s further assume that the employee later sells the shares (assuming a qualifying disposition) at $30 per share.
The total gain on this transaction will be $13 per share, or $30 less $17. The value of the discount paid will be treated as compensation income. In this example, $3 is subject to ordinary income rates. The remainder, $10 in our example, will be treated as a long-term capital gain that is subject to preferential capital gains tax treatment.
If we calculate the after-tax impact using simple tax assumptions (33% for ordinary income and 15% for long-term capital gains), we can illustrate the benefit of a qualifying disposition (all else being equal).
- Disqualifying Disposition
- $13 per share gain
- 33% tax = $4.29
- Net proceeds = $8.71
- Qualifying Disposition
- $13 per share gain
- 33% tax on $3 = $0.99
- 15% tax on $4 = $1.50
- Net proceeds = $10.51
The qualifying disposition results in over 15% greater after-tax wealth.
As I have discussed elsewhere, an ESPP can be a great way to participate in a growing company through the purchase of company stock. In fact, regardless of tax, one could suggest that participating in a good ESPP plan is a no-brainer when it comes to generating additional wealth.
Yet often, employees find themselves accruing shares of an ESPP over time. As these shares accumulate and become an increasing percentage of one’s net worth, it’s important to consider the tax impact of a sale. Remember, depending on what you own and when you own it, the after-tax value of said shares may be materially different. Furthermore, an understanding of taxes can lead to strategic planning that may differentiate between exercising one tranche of shares or another.
It would be easy to suggest that, based on the above scenario, a qualifying disposition of ESPP shares is the way to go. All else being equal, this is true. Paying less tax would be a good thing.
Unfortunately, all else is not equal in the real world. Waiting to perform a qualifying disposition means that an employee will need to hold the company shares for a longer period of time than an employee performing a disqualified disposition. Holding company shares may lead to an increase in concentration risk and/or volatility risk. While this may work in favor of the employee, it also may not.
More than concentration risk and an overly simplified answer that a qualifying disposition is always best because it results in less taxes, it’s important to know that the above illustration is a representation of what tax may look like. A detailed analysis of your personal tax situation and personal ESPP is necessary to see how your decisions impact your overall plan.
Tax services are not offered through, or supervised by Lincoln Investment, or Capital Analysts.
None of the information in this document should be considered as tax advice. You should consult your tax advisor for information concerning your individual situation.