Daniel Zajac, CFP®

Incentive Stock Options and Executive Compensation

qualifying disposition

5 Advantages of a Qualified Employee Stock Purchase Plan

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An employee stock purchase plan is an employee benefit that allows you to purchase shares of your employer’s company stock. It’s a convenient way to buy the shares, thanks to the fact that contributions are often deducted pre-tax directly from payroll.

Some purchase plans offer more than convenience, too, with additional perks like discounts on the share price. This can make participation in a plan seem like a no-brainer. However, before you make the decision to enroll, you should consider potential complications or downsides.

If you maintain a significant position in company stock through your other equity compensation holdings, such as incentive stock options, non-qualified stock options, or other restricted stock units (or awards), adding more exposure through an ESPP may or may not align with the objectives of your overall financial plan.

Or, if you’re risk-averse or otherwise unsure about owning stock, buying shares through an ESPP may not be the right choice for you.

This doesn’t mean you shouldn’t participate — only that you should carefully consider how an employee stock purchase plan fits into your overall financial plan.

To understand why it’s helpful to evaluate some of the key advantages of using an employee stock purchase plan.

How Employee Stock Purchase Plans Work

Let’s begin by making sure you understand a few key terms associated with employee stock purchase plans, and the timelines on which they operate. Generally speaking, an employee stock purchase plan follows this process:

  • Enrollment Period – The enrollment period is the time that you can choose whether or not to participate (and enroll) in your employee stock purchase plan.
  • Offering Date – The offering date is the date the employee stock purchase plan commences, and deductions from payroll begin. You should note the stock price on the offering date, because it may impact how much you pay to purchase shares of stock and the tax implications when you sell.
  • Offering Period – The offering period extends from the offering date, up to a maximum of 27 months, for a qualified employee stock purchase plan.
  • Purchase Period – A purchase period may be the entire offering period or a subset of the offering period. Commonly, a purchase period is every six months.
  • Purchase Date – A purchase date is the last day of a purchase period. On the purchase date, contributions to the plan are used to buy shares of stock.

Using an example to illustrate how this could work, let’s assume you have an employee stock purchase plan with an offering period of 24 months and a purchase period of 6 months.  When you enroll, your contributions to the plan often come right from your paycheck.

These contributions are held in trust during the first 6 months until the first purchase date. On that date, the company uses all contributions from the employees participating in the ESPP to buy shares of stock. This same contribution-and-purchase cycle will occur 3 more times, for a total of 4 purchase dates, until the 24-month offering period ends.

Not all ESPPs operate in such a straightforward manner, and there can be many nuances to the specific one your employer offers. You can look for your ESPP plan document (or request a copy from HR) to dig into the details — but in general, the process above is one that most ESPPs will follow in some form or fashion.

Now that you understand some of the basics, let’s look at why it’s worth considering enrolling and contributing to an ESPP.

1. It’s Usually Easy to Enroll and Get Started with an Employee Stock Purchase Plan

As mentioned, the process to enroll and contribute to an employee stock purchase plan is easy. Your company will typically inform you of your ability to participate in the plan and send the appropriate documentation. If you choose to participate, you notify your employer of that decision by completing the requisite paperwork.

When you enroll, you will need to indicate how much money you plan to contribute. This is often determined as a percentage of your salary or a stated dollar amount. Contributions are often deducted, pre-tax, from your paycheck.

For a qualified employee stock purchase plan, the annual contribution for a plan is typically $25,000. The maximum you can contribute to your ESPP may be limited by several factors, including your income and your plan rules.

2. An ESPP Often Lets You Purchase Shares Below Market Value

On the purchase date of the employee stock purchase plan, contributions are used to buy shares of stock. The cost of the shares may be equal to the fair market value of the stock on the purchase date — but many ESPPs include certain provisions like a purchase price discount and a lookback provision.

A purchase price discount is just as it sounds: if your company offers a discount, you will be able to purchase shares for less than you would have otherwise been able to do so. Typically, the discount is between 1 and 15% off the fair market value.

A lookback provision is a second feature that may positively impact the price you pay to purchase shares of stock. If your company offers a lookback provision, the ESPP will buy shares of stock at the better of the offering date price or the purchase date price.

Should the stock price increase between the offering date and the purchase date, you pay the lower grant date price of the stock. Should the stock price decrease between the offering date and purchase date, you pay the purchase date price.

The potential discount on share price and the lookback provision are great on their own — and some employee stock purchase plans offer both benefits. If your ESPP gives you the opportunity to use both, the two benefits can be “stacked.” That allows you to enjoy a discount on a lookback price.

3. You May Pay Long-Term Capital Gains on Some of the Proceeds

If you have a qualified ESPP, you do not owe any taxes when shares are purchased through the ESPP on your behalf. When you sell these shares, however, you create a taxable event that you must report when you file income taxes.

How you report this taxable event, and the subsequent tax due because of it, will depend on whether or not you achieved a qualifying disposition or a disqualifying disposition.

A qualifying disposition is a final sale of employee stock purchase plan stock that occurs at least 2 years from the offering date of the plan and 1 year from the purchase date of the shares. Anything that doesn’t meet both of these two rules is a disqualifying disposition.

If you have a qualifying disposition that has a gain, you may be able to pay long-term capital gains taxes on some of the taxable gain. Long term capital gains tax rates are lower than rates you’d otherwise have to pay if you were taxed at your ordinary income tax rate.

But there’s a downside of trying to achieve a qualifying disposition just so you can secure a favorable long-term capital gains tax rate: You have to buy and then hold the shares for at least one-year post-purchase. During this time, the stock price can go up and down, exposing you to market volatility and risk of loss of value.

4. You May Not Pay Social Security or Medicare Tax on Some of Your ESPP Profits

The nuance of income tax with an employee stock purchase plan can be complicated, and is beyond the scope of this article — but to give you a quick overview of this benefit, when you sell your shares via a qualifying or a disqualifying position, you will likely need to report some combination of compensation income and short- or long-term capital gains income.

You do not, however, need to report income that would be subject to Social Security or Medicare payroll tax. This may be different from other equity compensation that you may have, like non-qualified stock options or restricted stock units.

5. A Good ESPP Might Increase Your Overall Income

An employee stock purchase plan that offers a purchase price discount or a lookback provision might be an opportunity to increase your overall income and net worth — even if you already own a significant position in company stock. Here’s why:

Let’s assume that you participate in a plan and that you are allowed to purchase shares at a 15% discount. Then, you sell those same shares immediately after the purchase date. The plan’s discount may reduce the potential investment risk associated with participating in a stock plan.

Regardless of the purchase price and the potential tax bill associated with the sale, you may end up with more after-tax money than you would have had you not participated at all.

This possibility is a byproduct of buying something at a price that is less than what you sell it for. If you have this ability due to the features of your ESPP, it seems like something to consider this as part of your financial plan. Along with understanding how your ESPP works and how you may benefit from it, you will want to confirm that your plan allows for you to sell your shares immediately after they are purchased, or that you aren’t otherwise prohibited from selling.

Moving Forward with Your Employee Stock Purchase Plan

Employee stock purchase plans can be a great benefit to leverage because they allow for easy enrollment and purchase of company stock.

With the right provisions, ESPPs can also provide you with a quick, simple way to buy shares below market value and then immediately resell at market price to lock in a profit equal to your discount. If you also have a lookback provision? Even better. And of course, the potential for an appreciating stock price is always nice, too.

Just make sure you have a strategy in place to manage your cash flow before jumping into an employee stock purchase plan.

Remember that contributions usually happen via payroll deductions, so participating in an ESPP probably means less take-home pay. You also want to assess the investment risk of holding a more concentrated position, and evaluate how you will do your tax planning going forward to account for the added complication of buying and selling these shares.

Thanks to the benefits and features of these plans, ESPPs can be a great way to generate meaningful wealth.

The content herein is for illustrative purposes only and does not attempt to predict actual results of any particular investment.   Diversification does not guarantee a profit or protect against a loss.  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.  Tax services are not offered through, or supervised by, The Lincoln Investment Companies.

5 Reasons Why You Might Want a Disqualifying Disposition for Your Incentive Stock Options

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Want to pay less in taxes from the sale of your incentive stock options? While you can’t completely avoid taxes on a profit when you exercise and sell shares from ISOs, you can potentially earn the right to pay at long-term capital gains tax rates — which are lower than ordinary income.

This potential for paying a lower tax rate is one feature that tends to make incentive stock options more favorable than their non-qualified stock option counterpart.

But how do you secure that lower rate? You need a qualifying disposition, which you can secure if you meet both of the following standards:

  1. The final sale of the stock occurs at least 2 years past the grant date.
  2. The final sale of the stock occurs at least 1 year past the exercise date.

If you meet these two standards, the total realized profit between the grant price and the final sales price (times the number of shares sold) is subject to long-term capital gains tax.

Think Beyond Taxes Before Deciding on a Strategy for Exercising Incentive Stock Options

The allure of this potentially lower income tax treatment can be a strong motivator in seeking a qualifying disposition. But receiving preferential tax treatment is not the only option nor the only thing to consider when choosing a strategy for exercising ISOs and selling shares.

Anything that is not a qualifying disposition is a disqualifying disposition. With a disqualifying disposition, a portion of the profit may be subject to ordinary income tax rates and a portion may be subject to short- or long-term capital gains tax rates.

A disqualifying disposition will likely leave you with a different tax liability than a qualifying disposition, but that’s not a bad thing.

In fact, in some scenarios it might make more sense to intentionally do a disqualifying disposition, even while knowing that you won’t secure a long-term capital gains tax rate on your entire profit.

Here are a few reasons why you might intentionally choose a strategy for ISOs that ends in a disqualifying disposition.

Reason 1: A Disqualifying Position Allows to You Immediately Capture Potential Profits

When you exercise and hold incentive stock options with the intention of doing a qualifying disposition, you must hold the stock shares for at least 1 year past the exercise date. During this time, you are subject to the risk-reward tradeoff of owning a single stock position.

Because of this holding period requirement in which you can’t sell your shares, you don’t realize any profit (even if the share price goes up during this time). The value may change as the share price fluctuates, but it’s all unrealized losses or gains.

Only when you sell the shares do you realize a profit — if the price of the shares rose higher than the exercise price. But that’s a big “if,” which is why holding the shares in an attempt to achieve a qualifying disposition comes with risk.

If you do a disqualifying disposition whereby you exercise the incentive stock option and immediately sell the shares, you actually capture the value right away. You won’t be subject to the daily ups and downs of the stock price, or the risk that the eventual share price drops below the exercise price.

You take the unrealized profit on paper and turned it into cash you can actually use, making a disqualifying disposition an attractive technique if your primary goal is to capture profit immediately without subjecting yourself to the risk of a drop in the share’s value and price.

Reason 2: A Disqualifying Disposition May Help You Manage Cash Flow

When you exercise and hold incentive stock options past the calendar year-end, you will likely be subject to 2 cash calls:

  1. The cash required to buy the shares, and
  2. The cash required to pay the alternative minimum tax (AMT)

The cash required to buy the shares of stock is equal to:

“Exercise Price” X “Number of Shares Exercised”

In our example below this is equal to $10,000. If you have a greater number of options or a higher exercise price (or both), your cash call could be significantly higher.

The cash required to pay the alternative minimum tax is more complicated because it’s based on a number of personal tax return inputs. One of those inputs is related to the bargain element of your ISOs. The bargain element is equal to:

(“Market Price at Exercise” – “Exercise Price”) X “Number of ISOs Exercised”

The larger the bargain element, the greater the potential for the AMT. The greater the AMT, the greater the potential for cash flow issues when it’s time to pay that tax bill.

We can use a couple scenarios to show this. For the first, assume that you have the following grant of incentive stock options:

  • ISO shares: 10,000
  • Exercise price: $1.00/share
  • Market Price at Exercise: $50
  • AMT Rate: 28%

If you exercise and hold all 10,000 incentive stock options shares, the bargain element and subsequent AMT due will be:

(“Market Price at Exercise” – “Exercise Price”) X “Number of ISOs Exercised”

($50 – $1) x 10,000 = $490,000

“Bargain Element” X “AMT Rate” = “AMT Due”

$490,000 x .28 = $137,200

That means you need $137,200 additional in cash to pay that tax bill. Herein lies the issue: where does the money come from to pay for the AMT due?

One way to cover the $137,200 cost of the AMT is to write a check from your other personal assets, if you have that type of cash available. Not everyone does (or if they do, they don’t want to use it to pay taxes), so a second option might be to do a disqualifying disposition of the incentive stock option shares.

Let’s look at a second scenario in which, instead of exercising and holding 10,000 incentive stock option shares, you exercise and hold 7,000 shares and exercise and immediately sell 3,000 shares.

When you sell the shares, you’ll immediately capture the profit from the sale:

(“Market Price at Exercise – Exercise Price) x “Shares Exercised and Sold”

($50 – $1) x 3,000 = $147,000

If you exercise and hold 10,000 shares, you need to come up with enough cash to pay the AMT. In this scenario when you exercise and hold 7,000 shares — but also and exercise and sell 3,000 — you’ve created a positive inflow of $147,000 that can be used to pay the tax bill.

Reason 3: You Might Owe the Same in Taxes Regardless of Disposition Type

Many people don’t want to end up with a disqualifying disposition because they believe they’ll pay significantly more income tax this way. But that’s not always the case.

The way your taxes are calculated are different depending on whether you have a qualifying or disqualifying disposition. But in some cases, the amount of taxes owed can be very close.

When you exercise and sell as a disqualifying disposition, your income tax calculation will likely include two parts. The first part is the profit from the exercise and sell.

This profit will likely be subject to ordinary income tax. If we follow scenario 2 above with 3,000 shares as a disqualifying disposition, the profit of $147,000 will be subject to ordinary income. If we assume at 32% income tax rate, the total tax due will be $47,040.

A disqualifying disposition of some of the shares also means that the AMT adjustment for the remaining exercised and held shares will be lower than had you exercised and held all the shares.

In scenario 1 above, the bargain element when you held 10,000 shares is $490,000. In scenario 2, only 7,000 shares were exercised and held. These make up part 2 of the tax calculation.

The bargain element is:

(“Market Price at Exercise” – “Exercise Price”) x “Shares Exercised and Held”

($50 – $1) x 7,000

= $343,000

Assuming a flat 28% flat AMT tax rate, the AMT due (our part 2) will be $96,040. If we add these two taxes together, the total tax from the original 10,000 shares will be $143,080.

Compare that to the example above when you exercised and held 10,000 shares and the total tax due was $137,200.

The difference in total tax due for this calendar year is under $6,000, which is a relatively small amount compared to all the numbers we’re using here.

When you owe a similar amount in taxes either way, a disqualifying disposition may make more sense because you don’t subject yourself to the risks of holding a single concentrated stock position.

That being said, you may want to work with an accountant or an advisor who can model the two for you to see what it may look like in your specific situation before making a decision.

Reason 4: A Disqualifying Disposition Could Lead to a Reduced Position in Company Stock

If you are seeking to reduce your position in company stock, an intentional disqualifying disposition is one way to do so.

Looking back at the examples above, the end result of scenario 1 is owning 10,000 shares of company stock valued at $500,000. The end result of scenario 2 is owning 7,000 shares valued at $350,000. That’s a 30% reduction in exposure to the company stock by using a disqualifying disposition.

This could be an important consideration if you have a large portion of your net worth already tied up in one company stock, you want to retire and need to diversify, or you otherwise feel as though the stock price has peaked.

But if you are bullish on the stock, adequately understand the risk/reward tradeoff, and/or have other assets or means on which to survive, you might deliberately choose to own a large position in the stock.

You need to determine how much concentration risk is appropriate for you to take on, which should be considered in the larger context of your comprehensive financial plan.

Reason 5: You May Still Be Able to Participate in the Upside of the Company Stock

Many people feel influenced to act one way or another because they fear missing out. As this pertains to owning company stock, you might feel the fear of selling your stock shares too soon (even if it’s a profit) and missing out on being part of a potential meteoric rise if the company becomes “the next Apple.”

This isn’t a reason to avoid a disqualifying disposition, though. Using this strategy to sell some of your shares may still allow you to participate in the upside of the company.

Again, using our example, in scenario 1 you retain 10,000 shares and in scenario 2 you retain 7,000 shares. If the stock price quadruples from $50 per share to $200 per share, the value of your 10,000 shares will be $2,000,000 and the value of your 7,000 will be $1,400,000.

Clearly there is meaningful difference between these two figures (30%). But even in scenario 2, you very much benefitted from and participated in the growth of the value of the company and did not miss out on much.

Is a Disqualifying Disposition A Good Idea?

A disqualifying disposition may be a good technique to implement a part of a liquidation strategy for your incentive stock options.

It could help you create positive cash flow that can be used to offset the tax liability, manage your position in one stock while still allowing for participation in the upside, or capture profits immediately (instead of leaving that to chance) along the way.

These reasons are why it may make sense to explore how exercising and selling shares from ISOs as a disqualifying disposition fits into your overall plan, as compared to blindly seeking a qualifying disposition in an effort to pay long-term capital gains rates instead of a potentially higher ordinary income tax rate.

The content herein is for illustrative purposes only and does not attempt to predict actual results of any particular investment.   Diversification does not guarantee a profit or protect against a loss.  Nothing contained herein should be construed as a recommendation to buy or sell any securities. As with all investments, past performance is no guarantee of future results. All investments are subject to risk, including the risk of principal loss.  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.  Tax services are not offered through, or supervised by, The Lincoln Investment Companies.

 

 

 

How and When Are Incentive Stock Options Taxable?

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Incentive stock options are a form of employee compensation that allows you to participate in the appreciating value of a company stock price.

Similar to non-qualified stock options, incentive stock options (ISOs) allow for the purchase of a stock at a predetermined share price. If the current share price of the stock is above the price at which you can exercise your right to buy the share, you have an “in the money” option.

But if the current market price of the stock is below the price at which you can buy the share, you likely pass on your right to exercise the option and buy the shares.

If you find yourself with ISOs, it will be helpful to have a working knowledge of how this type of equity compensation is taxed.

Generally speaking, ISOs aren’t taxed until you exercise the option to buy the share – but over the lifespan of an incentive stock option, you may find yourself dealing with several types of taxes along the way.

Taxes on Incentive Stock Options When You Exercise

The first taxable event occurs when you exercise your ISOs. When you exercise your incentive stock options, you create a reportable tax event that is based on the spread between the grant price of the option and the fair market value of the stock when you exercise, multiplied by the numbers of shares you exercise.

For example, let’s assume you have the following:

  • 10,000 ISOs
  • $1.00 grant price
  • $25.00 fair market value at exercise

In this example, the $24 spread between the grant price and the fair market value at exercise X 10,000 shares is $240,000.

This amount is known as the bargain element. The type of tax you may pay on the bargain element depends on what you do next.

The Difference Between Qualifying vs. Disqualifying Disposition of Incentive Stock Options

Incentive stock options are often preferred to non-qualified stock options because you have the potential to pay long term capital gains rates on the bargain element of the stock should you meet specific holding requirements:

  1. The final sale of the stock must be at least 2 years from the grant date, AND
  2. The final sale of the stock must be at least 1 year from the exercise date.

Should you meet these requirements, the bargain element and future gain gets taxed at preferential rates. This is known as a qualifying disposition.

If you don’t meet the requirements you have a disqualifying disposition and the bargain element will be taxed as ordinary income. It won’t be subject to Social Security and Medicare wage tax (I point this out as a difference between NSOs and ISOs. NSOs are subject to Social Security and Medicare wage tax).

Tax on a Disqualifying Disposition of Incentive Stock Options

Let’s assume you immediately exercise and sell the shares from our hypothetical example above. In this scenario, you turned stock options into cash you can use for personal expenses or allocate to savings.

The rules of a disqualifying disposition state that the bargain element will be treated as ordinary income. If we assume a flat 35% tax bracket, we can assume you will pay $84,000 in tax on your exercise and sell of $240,000 worth of incentive stock options.

Tax on a Qualifying Disposition of Incentive Stock Options

Continuing the above example and assuming you exercise and then hold your ISOs, the tax implications become increasingly more complicated. You may be subject to the alternative minimum tax, or AMT, and long-term capital gains rates (assuming you have a gain when you sell).

AMT is the result of a secondary tax calculation that occurs every year when you file your tax return. As a taxpayer, you generally pay the higher of the regular tax calculation or the tentative minimum tax calculation. The difference you pay if the tentative minimum tax is higher is the AMT.

When you exercise and hold incentive stock options pas the calendar year end, no earned income is reported on your W2. Your adjusted gross income on your regular tax calculation won’t change.

But the bargain element is a tax preference item for calculating the tentative minimum tax. This means that if you exercise and hold incentive stock options, it’s possible that this tentative minimum tax calculation may be the higher of the two. If it is, you’re required to pay that amount instead.

Following the example above, let’s assume the same situation and an AMT tax rate of 28%:

  • 10,000 ISOs
  • $1.00 grant price
  • $25.00 fair market value at exercise

In this scenario, the $240,000 of bargain element will result in a tentative minimum tax of $67,200.

If your tentative minimum tax is higher than your regular tax, you will owe the higher of the two. Tentative minimum tax being the higher of the two is often a direct result of the exercise of ISOs.

Eventually, you’ll probably sell the ISOs you exercised and held. If you sell your shares as a qualifying disposition, you’ll pay long-term capital gains on the entire amount from the original grant price of the stock to the final sales price.

Continuing our example from above, let’s assume that since you exercised the shares, the share price has increased from $25 per share to $65 per share.

  • 10,000 ISOs
  • $1.00 grant price
  • $25.00 fair market value at exercise
  • $65.00 final sale price

Assuming a qualifying disposition, the entire amount from $1 per share to $65 per share should be taxed at long-term capital gains rates. This gain is $640,000. Assuming a flat 15% tax bracket, you will be subject to $96,000 in capital gains tax.

Alternative Minimum Tax Credits

If you are following the above scenario, you may have noticed that you have in fact paid tax twice on a certain portion of the hypothetical example:

  1. You paid the AMT on the amount between $1 and $25 when you exercised and held and
  2. You paid LTCG on the amount between $1 and $25 when you sold the shares

Clearly, this would be a disadvantageous tax scenario. Enter the AMT credit.

When you sell your incentive stock option shares in a final sale, you “undo” the original bargain element that caused you to pay AMT. This “undoing” on your tax return is addressed by figuring regular capital gains and AMT capital gains.  This calculation may allow you to receive an AMT credit to cover the tax you already paid.

Said another way, when you sell your shares, you may get some or all of the money you paid on AMT when you exercised and held back to you.

This explains why much of the attention surrounding incentive stock options centers around AMT. A significant AMT bill may be a reason (or not) to exercise your shares. It should certainly be a reason to consider what your options strategy may be.

Other Advanced Tax Considerations to Remember

In addition to AMT, you may want to think about long-term capital gains. Long-term capital gains may be taxed as low as 0% — or they could be taxed at 15%, or even as high at 20% when your income exceeds $496,600 (married filing jointly in 2020).

When planning for your final sale of stock, it is important to understand what other income you have and how much room you have in various capital gains tax brackets.

For example, one strategy may be to “fill up” your 15% capital gains tax bracket. You can run detailed tax projections to determine how much capital gains you can incur, therefore determining how much stock you can sell, so you only pay 15% capital gains tax.

To do this calculation well, it may take the resources of a good accountant or financial advisor. When considering you could pay far less in tax by getting these complicated decisions correct, it may be well worth hiring a professional to help you.

You may also need to deal with the net investment income tax (NIIT). This tax is paid on capital assets (which are likely the shares of company stock you sell) when your adjusted gross income exceeds $250,000 (for married filing jointly in 2020).

The amount in excess of $250,000 is taxed at 3.8%. If we combine the NIIT with the highest capital gains bracket above (20% + 3.8%), you can see that your long-term capital gains may be taxed as high as 23.8%.

And while not exactly a direct tax in the same sense as long-term capital gains and net investment income tax, you should still pay attention to how AMT is calculated and how it impacts how much tax you pay.

What to Know About Tax and Incentive Stock Options

You may face many different types of taxes owed when you have incentive stock options. The timing of your exercise, hold, and final sale of the stock options can only further intensify the difficulty in understanding which of those taxes apply and what moves to make to reduce your bill.

Unfortunately, this complexity and uncertainty often leads to inaction because people feel afraid of the unknown — or they’re afraid of making a mistake.

If you find yourself with incentive stock options, begin learning about the tax you may pay and when. If you are not prepared to handle that on your own, it may make sense to work with someone who is an expert in tax and other financial planning needs that can arise.

Knowing the rules and planning a good exercise strategy for your incentive stock options can lead to a material difference in the amount you receive in the end.

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.  Tax services are not offered through, or supervised by, The Lincoln Investment Companies.

The hypothetical examples included are for illustrative purposes only and do not attempt to predict actual results of any particular investment.

How a Qualifying Disposition Impacts Your ESPP

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An employee stock purchase plan (ESPP) may provide you with a convenient way to purchase company stock. Often offered via payroll deduction, you can easily allocate money to the ESPP via your paycheck (similar to how you contribute to a 401(k)).

In addition, your ESPP may offer a purchase discount of up to 15% on the company stock, allowing you to purchase company stock at a lower price than what you could have in a typical investment account.

Your stock shares accumulate in a non-IRA investment account, which means that income tax is an important consideration when you have an ESPP. Unfortunately, figuring out the income tax rules for ESPPs isn’t always particularly easy.

Depending on how long you own your shares, the purchase price, the discount applied, and the amount of gain or loss, you may need to consider more than one type of income tax. Here’s how to sift through the details to better understand your potential tax obligations.

ESPP Tax at When Your Shares are Purchased

When you purchase shares via an ESPP, no tax is due, and no tax is reported. It’s 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. The purchase of shares through an ESPP is not a reportable event for tax purposes.

That doesn’t mean, however, that the information pertaining to the purchase price and the discount applied on the purchase is irrelevant. In fact, both the purchase price and the discount are important when calculating potential taxes you may owe.

When you sell shares acquired via your 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 comes with special holding periods that dictate if profits earned on the sale are treated as compensation income or as a capital gain. Your holding period will determine if you have a disqualifying disposition or a qualifying disposition.

A qualifying disposition of ESPP shares is anything that meets the following standards:

  • 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 doesn’t meet these criteria is a disqualifying disposition of ESPP shares.

From a tax standpoint, there are generally two brackets when considering what tax may be owed:

  • The portion of the proceeds that will be taxed as compensation income
  • The portion of the proceeds that will be taxed as a capital asset (short term or long term capital gains)

How Taxation of an ESPP Works in the Real World

A quick and simple hypothetical example can help illustrate.

Let’s assume you purchase shares of stock through an ESPP with a 15% discount and a lookback provision. The price at the beginning of the offering period was $20 per share, and at the end of the purchase period, it’s $25 per share. This means you would have bought shares of the company at $17 per share, a 15% discount from $20 per share (the lower of the offering period price and the purchase date price).

Now, let’s say you sell your 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?

If we assume a disqualifying disposition, you report compensation income on the discounted purchase price ($17) to the price of the stock at the end of the purchase period ($25) or $8 per share. This amount is taxed at your ordinary income tax rates.  Your cost basis of the shares moving forward is $25 per share.

The final sales price ($30 per share) less the cost basis ($25 per share) 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.

What Happens If The ESPP Share Price Goes Down

The hypothetical example above illustrates the tax if the share prices increase. But what happens if the share price goes down after the purchase of the shares?

In this scenario, it’s possible that you could report both compensation income and a capital loss.

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). You will report compensation income equal on the spread between the discounted purchase price ($17) and the price at the end of the offering period ($25), or $8 per share.

Because you report and pay tax on the earned income above, your cost basis is equal 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.

Tax for a Qualifying Disposition of ESPP Share

If you meet the standard for a qualifying disposition, you will likely report both earned income and long-term capital gain income.

Let’s assume that you purchase shares of stock through an ESPP with a 15% discount and a lookback provision. You buy shares at $17 per share (a 15% discount from the $20 per share price).

Again, let’s say you later sell the shares at $30 per share. The total gain on this transaction will be $13 per share, or $30 less the $17 you paid for the share.

The value of the discount received will be treated as compensation income. In this example, $3 is subject to ordinary income rates. The remainder, $10, is treated as a long-term capital gain subject to preferential capital gains tax treatment.

If we calculate the after-tax impact using simple tax assumptions (33% for earned income and 15% for long-term capital gains), we can illustrate the benefit of a qualifying disposition (all else being equal):

  • Disqualifying Disposition
    • $30 sales price
    • $13 per share gain
    • 33% tax = $4.29
    • After tax profit = $8.71
  • Qualifying Disposition
    • $30 sales price
    • $13 per share gain
    • 33% tax on $3 = $0.99
    • 15% tax on $10 = $1.50
    • After tax profit = $10.51

The qualifying disposition results in over 20% greater after-tax wealth.  However, it always required that you will be required to hold the shares of stock until you meet the holding period requirements.  During this time, you will be subject to the normal market fluctuations of a single stock.  This investment risk may or may not be worth the potential tax benefit.

Final Thoughts on ESPP Taxes

An ESPP may be a great way to participate in a growing company through the purchase of company stock. In many cases, participating in a good ESPP plan is a no-brainer when it comes to generating additional wealth.

But that does not mean that holding the shares for the long term is best.

If you use an ESPP, you may find yourself accruing shares. As these shares accumulate and become an increasing percentage of your net worth, it’s important to consider not only how that kind of asset fits into your financial plan, but also what the tax consequences of a sale of those assets could be.

It’s easy to think a qualifying disposition of ESPP shares is the way to go as it minimizes your tax bill. All else being equal, this is arguably true; paying less tax would be a good thing.

Unfortunately, the desire to pay less tax requires you to hold your shares long enough to meet the standard of a qualifying disposition. Holding company shares may lead to an increase in concentration risk and/or volatility risk.

While this may work in your favor if the stock price goes up, it also has the capability to reduce your wealth if the stock price goes down.

This is why it’s important to balance your tax planning objectives with your investment risk tolerance. Combining this information with a detailed tax analysis can help you understand what your tax may look like.

Tax services are not offered through, or supervised by Lincoln Investment, or Capital Analysts. The content herein is for illustrative purposes only and does not attempt to predict actual results of any particular investment.   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.  

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