Through an Employee Stock Purchase Plan (ESPP), employees can buy stock in their employer’s business through payroll deductions. Often, employers will design the plan so employees are buying the stock at a discounted price compared to prices for the stock on the open markets. There is no tax impact until the employee sells the stock that was acquired through the ESPP.
Employee Stock Purchase Plans go through five phases during its lifecycle:
- Grant – the employer gives employees the opportunity to participate in the ESPP.
- Offering period – the employer deducts an amount you choose from your paycheck and sets that money aside in an escrow account.
- Purchase and Transfer – employer transfers shares of stock to your brokerage account.
- Holding period – the period of time during which you own the stock.
- Sale or Disposition – when the stock is sold or otherwise disposed of.
Buying Employer Stock at a Discount
A big advantage of ESPPs is that employees can purchase shares of their employer’s stock at a discount. Under the tax rules for ESPPs, the price that an employee pays for one share of stock (which is called the “exercise price”) cannot be less than the lower of the following two amounts:
- 85% of the fair market value of the stock on the grant date; or
- 85% of the fair market value of the stock on the exercise date.
Fair market value (FMV) refers to the price at which a company’s stock is trading on the open markets. If a company is privately owned, the value of the stock might be based on a formal appraisal of the company’s valuation.
Not all employers offer discounts on the purchase price of the stock, and some employers may offer a smaller discount. We recommend that you review your employer’s ESPP to find out what type of discount is offered.
This discount on the price of the stock makes it easier for employees to generate a profit on their investment.
Tax Treatment of Employee Stock Purchase Plans
Stock acquired through an ESPP is taxed when the stock is sold.
There is a three part process to determining the tax treatment of selling ESPP.
First, we determine whether the ESPP stock was sold in a qualifying disposition or in a non-qualifying disposition. Second, we separate out the ESPP stock sale into two components: compensation income and capital gain income. Third, we calculate the tax impact of selling the ESPP stock.
Step 1: Qualifying or Non-qualifying Disposition
A qualifying disposition is any sale or transfer of ESPP stock where the person owned the ESPP stock:
- More than one year after the date of transfer, and
- More than two years after the date the ESPP options were granted.
A non-qualifying disposition is any sale or transfer of ESPP stock that does not meet the criteria spelled out above for a qualifying disposition. In other words, a non-qualifying disposition is any sale where the person owned the ESPP stock for one year or less after the transfer date or owned the ESPP stock for two years or less after the grant date.
Step 2: Compensation Income
For qualifying dispositions, compensation income is the smaller of the following two calculations:
- The fair market value of the stock on the grant date, minus the price paid to buy the stock; or
- The fair market value of the stock on the date the stock was sold, minus the price paid to buy the stock.
For non-qualifying dispositions, compensation income is
The fair market value of the stock on the purchase date, minus the price paid to buy the stock.
Compensation income is added to a person’s wage income on the day the stock is sold. This compensation income is subject to the ordinary tax rates. However, this compensation income is not subject to Social Security and Medicare taxes.
Step 3: Capital Gain Income
Any additional gain beyond the compensation income is referred to as a capital gain. For ESPP stock, that means the capital gain income is equal to the final sale price minus the initial price paid (including any fees or trading commission) minus the portion treated as compensation income.
Capital gain income is categorized either as short-term gain or long-term gain. Short-term gains are taxed at the ordinary tax rates, just like compensation income. Long-term gains are taxed at the more favorable capital gains tax rates, which are lower than the ordinary rates.
How to Get the Best Tax Impact on ESPP
For tax planning, we aim for the least amount of tax when selling ESPP stock.
In order to find the least amount of tax, we need to analyze each component: compensation income and capital gain income. Whenever possible, we want to push more income into long-term gains.
Let’s see how this plays out in two scenarios.
Scenario 1. Suppose the value of the stock continuously increases from the grant date, to the purchase date, and to the sale date. In this situation, a qualifying disposition results in the least amount of compensation income, and the remainder of the gain being treated as long-term gains.
Scenario 2. Suppose the value of the stock declines from the grant date to the purchase date, and then the value of the stock rises from the purchase date to the sale date. In this situation, a disqualifying disposition results in the least amount of compensation income.
For this reason, we cannot assume that a qualifying disposition always results in the least amount of tax.
A better way to work with the situation is to calculate the tax impacts assuming different selling prices and selling dates and from there determine if there is an optimal date or price point for selling the ESPP stock.
Tax Move Takeaways
- Before selling shares, run a projection to calculate the tax impact of selling shares. Try to figure out if there’s a significant tax benefit to holding the shares long enough to be a qualifying disposition as compared to a non-qualifying disposition.
- If it makes sense to do so from an investment perspective, consider holding the shares more than one year after the purchase date, so that the capital gain income will be taxed at the lower tax rates for long-term gains.
- Keep all documents relating to your employee stock purchase plan, especially Form 3922, Form 1099-B and any statements from the broker. This will save you a lot of time when filing your tax tax return.
|Qualifying disposition if the worker:
||Non-qualifying disposition (aka disqualifying disposition): any other sale.|
|Sale or Disposition||
Done filing taxes alone? Lock in discounted 2019 pricing!