Employee Stock Purchase Plans offer you, as the employee, a great way invest in the stock of your company at a discount. Previously I went through 5 important terms regarding ESPP stock. Now it’s time to get an understanding of how taxes work when you sell your ESPP shares. Because you are purchasing shares at a discount the IRS considers the “discount” to be income you are earning from your company. You don’t have to report that “income” when you buy the ESPP shares, but you will have to report it when you sell your shares. The profits you earn above your discount are charged at capital gains tax rates, similar to other investments. The IRS looks at how long you have held your ESPP shares to determine how they will tax you. Be sure you understand how the taxes work on your ESPP shares to avoid double paying taxes when you sell your shares.
When you sell your ESPP shares the sale is considered a “Qualified Disposition” if you meet the holding period requirement*. You meet the holding period requirement on the later of the following dates:
- The date 2 years after the first day of the offering period*.
- The date 1 year after you purchased the stock.
With a qualified disposition you pay income tax only on your 15% discount*. As you will recall the discount is taken off the lower of (a) the price of the shares on the first day of the offering period or (b) the price of the shares on the last date of the offering period. Any additional gains are paid at the lower capital gains tax rates.
Your company’s stock is priced at $30 on the first day of the offering period and $40 on the day your company purchases your shares. The 15% discount will be taken off the $30. You will pay $25.50 per share. You decide to sell your shares 2 years after the first day of the offering period for $50 per share.
You paid $25.50 per share and your discount was $4.50 per share ($30 – $25.50). You will pay income tax on $4.50 per share and capital gains tax on $20 ($50 sale price – $30) per share.
If you sell your ESPP shares held for less than 2 years from grant (beginning of offering period*) or less than 1 year after purchase you have made a disqualifying disposition. If you have an early disposition you will have to report income equal to the entire “bargain element” which is often more than the 15% discount. The bargain element is the difference between the price you paid for the stock and the value of the stock on the date it was purchased. Unlike in a qualifying distribution you don’t get to consider the lower of the first day of the offering period and the purchase price – you must use the purchase price.
Let’s go back to our previous example of the stock you purchased for $25.50 per share. If you have an early disposition you will have to report income of $14.50 ($40 – $25.50) per share. The $40 is used because that is the price of the stock on the day it was purchased. If the day you sell your stock it is worth more than $40 then you will pay capital gains tax on the additional gain. So if the stock is worth $50 then you will pay income tax on $14.50 per share (bargain element) and capital gains tax on your $10 additional gain.
*if any of these terms are confusing go to ESPP Terms Article
Reporting your ESPP Sales
When it is time to pay your taxes you need to take a few steps to make sure you calculate the correct amount you should pay in income tax vs capital gains tax. Taking these steps also helps you avoid paying duplicate taxes.
You will need to look at 3 forms specifically:
W2 – Your W2 shows your income for the year. In the year you sell your ESPP shares it will include the discount you received when you purchased your options. Some companies list the amount of income being reported based on the sale of ESPP shares in Box 14 on your W2, but that is not required. If yours is not shown in Box 14, you need to look at our next form, Form 3922.
Form 3922 – You will receive this form when you purchase your ESPP shares. If your employer doesn’t report your discount amount in Box 14 on your W2 you can refer to Form 3922 to get the exact amount of discount you received. If you just look at the 1099-B from your broker you will not know how much of the discount you have already paid taxes on.
1099-B – This form will come from your broker at it will show you your cost basis and the price you sold your shares for. Ordinarily this is the all the information you need, but as we pointed out your employer has included your discount amount on your W2 already. You are paying income tax on that discount, but that is not reflected on your 1099-B. If you just follow the cost basis and sales price on your form 1099-B you will potentially duplicate some of the taxes you have already paid.
A good option
Don’t let some of the complexities of the tax system discourage you from purchasing ESPP shares. If it makes sense with the rest of your financial goals Employee Stock Purchase Plans are a fantastic investment. Try to hold onto them to meet the holding period requirement and make sure you understand how your shares will be taxed when they are sold.
If you are looking for more in-depth reading about ESPP shares check out this very detailed overview.
Need help creating a plan to purchase and/or sell your ESPP shares keeping the tax consequences in mind? Reach out to schedule a call.
Have a friend who has ESPP shares? Make sure she knows how the taxes work by sending her this article.