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.
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.
This material is intended for informational/educational purposes only and should not be construed as investment, tax, or legal advice, a solicitation, or a recommendation to buy or sell any security or investment product. Hypothetical examples contained herein are for illustrative purposes only and do not reflect, nor attempt to predict, actual results of any investment. The information contained herein is taken from sources believed to be reliable, however accuracy or completeness cannot be guaranteed. Please contact your financial, tax, and legal professionals for more information specific to your situation. Investments are subject to risk, including the loss of principal. Because investment return and principal value fluctuate, shares may be worth more or less than their original value. Some investments are not suitable for all investors, and there is no guarantee that any investing goal will be met. Past performance is no guarantee of future results. Talk to your financial advisor before making any investing decisions.