ESPPs 101: Taxation Made Simple (Part 1)

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Your employee stock purchase plan may be one of the best benefits offered by your company. However, to appreciate the advantages of enrolling in the ESPP you must understand the tax consequences of participation. Part 1 explains the basics of ESPP taxation and the tax treatment when the special ESPP holding period is not met (disqualifying disposition). Part 2 explains the tax treatment that applies when you meet the ESPP holding-period requirement, along with the taxation of nonqualified ESPPs and some ESPP tax-planning concepts.

• Review Of ESPP Basics
• Taxation Of Tax-Qualified ESPPs: Holding Period Not Met (Disqualifying Disposition)
• Ordinary Income Calculation (Disqualifying Disposition) With Examples

Review Of ESPP Basics

Let's start with a brief review of employee stock purchase plans. An ESPP is a type of stock plan that lets you use after-tax payroll deductions to acquire shares of your company's stock. See the prior article in the ESPPs 101 series for an explanation of the key dates and terms in employee stock purchase plans.

There are two major types of ESPPs: those which are tax-qualified under Section 423 of the Internal Revenue Code and those which are not tax-qualified in this way.

Section 423 ESPPs

In the United States, "tax-qualified" employee stock purchase plans, which confer special tax advantages discussed below, are structured to meet the requirements of IRC Section 423. (Tax-qualified ESPPs in the US are thus often called Section 423 plans. See the Global Tax Guide for special ESPP arrangements in other countries.) The purchase-price discount can be any amount up to 15% (i.e. the purchase price can be as low as 85% of the stock's fair market value). When the plan has a lookback feature, this discounted price is based on the market price either on the first day of the offering period or on the purchase date (whichever is lower).

You can't purchase in any calendar year more than $25,000 in shares under the plan (valued at the undiscounted stock price on first day of the offering period). Unused amounts can be carried forward if the offering period spans more than one year.

Another advantage of these ESPPs is that you have no withholding, not even for Social Security or Medicare taxes, regardless of when you sell the ESPP stock. While at sale you will owe income tax with your tax return or through estimated taxes, participants in Section 423 ESPPs never have to pay Social Security and Medicare.

Nonqualified ESPPs

Nonqualified plans are not structured to meet the requirements of IRC Section 423. If the plan is structured like a qualified Section 423 plan except for the feature that disqualifies it, it will work in the same way with the payroll deduction but without the favorable tax treatment explained below. In some ways, a nonqualified ESPP resembles a nonqualified stock option with set exercise dates (but with set purchase dates instead). A company may have a nonqualified ESPP because it offers more flexibility in plan terms, eligibility, and design than a Section 423 ESPP.

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Taxation Of Tax-Qualified ESPPs: Holding Period Not Met (Disqualifying Disposition)

The tax consequences to you depend on whether or not you meet the special holding-period requirements for Section 423 ESPPs under the Internal Revenue Code: two years from the start of the offering and one year from purchase. The tax consequences for you also depend on stock-price changes between the purchase and your eventual sale.

Sell Too Soon: Disqualifying Disposition

Not meeting the holding-period requirement of two years from offering/grant and one year from purchase is called a "disqualifying disposition" (sometimes abbreviated DD). Essentially, this occurs when you sell, transfer, or gift the stock too soon to get all of the favorable tax treatment that is available with tax-qualified ESPPs. Transfers to a spouse, to a broker, in a divorce, or after your death are not dispositions.

Alert: If you sell or otherwise dispose of the stock without meeting both ESPP holding periods, you will recognize ordinary income at the time of sale or other disposition (e.g. a gift). ESPP participants are sometimes tripped up because they hold the stock long enough to get long-term capital gains rates for one year but sell the stock within two years of the grant (or enrollment) date. This sale is still a disqualifying disposition.

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Ordinary Income Calculation With Examples

The amount of ordinary income is equal to the difference between the fair market value of the stock at the date of purchase and your purchase price. In other words, your ordinary income is measured by the "spread" on the purchase date, regardless of whether your purchase price is calculated on the first day of the offering period. This income will appear on your Form W-2.

This spread amount is considered ordinary income in the year of sale or disposition even if the stock price falls after purchase and you do not recognize any actual gain when you eventually sell the shares. In addition, the difference between your sale price and your cost basis (i.e. the value of the stock at purchase) will be a capital gain or loss. It will be long-term if the stock has been held for more than one year. You can still have long-term capital gain or loss and an ESPP disqualifying disposition if you sell the stock less than two years after your ESPP enrollment.

Example (stock sale in up market): The company uses a 15% discount.

* Short-term if sale less than one year from purchase; long-term if sale at least one year after purchase.

Example (down market): Using the facts of the prior example:

For the tax treatment that applies when you meet the ESPP holding-period requirement, along with the taxation of nonqualified ESPPs and some ESPP tax-planning concepts, see Part 2 of this article series.

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Got another four minutes? Watch our popular video on ESPP taxation.