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Investment Planning |
Employee Stock Purchase Plans
If your employer offers an Employee Stock Purchase Plan (ESPP), you can purchase company stock for a discount from the stock's fair market value. Usually the discount allows you to buy the stock at 85 percent of the stock's value.
The basic tax consequence of ESPP transactions is that you'll have ordinary income when you purchase shares and capital gain on the sale of the shares. The amount of the discount, or the difference between the price you paid and the fair market value, will be included in your W-2. When you sell the shares, the capital gain may be taxed at the lower capital gain rates, depending upon how long you held the shares.
A common mistake that people make when they sell ESPP shares and need to figure out their cost basis for the shares is forgetting to add the amount that was included in their W-2 to the amount they paid for the stock. It's important to add in the amount included in your W-2, since you've already paid tax on this! The amount included in your W-2 is sometimes called the "discount to market value." When you add this to your cost basis, it makes your capital gain and the corresponding tax as small as possible.
Here are some helpful definitions to know when analyzing your ESPP shares:
- The enrollment date is the first day of the offering period (also called subscription period) for which you can make stock purchases.
- The exercise date is the last day in the purchase period.
- Your purchase price is based on the lower of the stock's price at the beginning or the end of the subscription period. If the price rises throughout the year, your price will be based on the beginning of the period. For example, at the beginning of the subscription period for YourCompany.com, the shares traded at $90. At the end of the period, shares traded at $115. The price you pay for the shares will be $90.
- The purchase period depends on your company's plan. Many companies have either a six-month or one year period during which after-tax dollars are deducted from an employee's paycheck to purchase company stock.
- The plan document is a legal document defining the workings of the ESPP plan. It's a good idea to get a copy of your employer's ESPP plan document for current and future reference.
Most companies that offer an ESPP allow company employees to purchase shares of the company's stock at a discount. The discount is based on the stock's fair market value at a pre-determined date. Your employer takes payroll deductions from your paycheck to purchase company stock on your behalf. You, the employee, will be considered to have earned income for the amount of the discount.
Another way to state this is that you'll have earned income over your purchase price for the amount of the excess of the fair market value at the exercise date. For example, you're able to purchase YourCompany.com shares, currently trading at $100, for $85. The $15 discount will be considered income to you, and you will be subject to tax on this amount.
Your company should include the value of this discount in your W-2 and accordingly you'll pay tax on it when you file your tax return. The amount of the discount will be taxed to you at ordinary income tax rates.
The reason for this is that you can immediately turn around and sell the shares as soon as you receive them. Including the value of your discount in your W-2 taxes it at ordinary income tax rates, and an immediate sale (cost basis of $100 and market value of $100) would result in zero capital gain. If the discount were not included in your W-2, your cost basis would be the amount you purchased the shares for, $85, and you would have a $15 capital gain, which would be taxed at the lower capital gain rate. In order to avoid turning ordinary income into capital gain income, the IRS mandates that the discount be taxable income included in your W-2.
Capital gain treatment is usually better than ordinary income treatment, since the long term capital gains rates will always be lower than ordinary income rates. Determining whether you are eligible for long term capital gain treatment on ESPP sales is dependent on several factors.
The holding period of the stock is one factor. The holding period determines whether a capital gain (or loss) will be treated as short or long term. Long-term gain treatment exists if you hold the shares at least one year and one day beyond the last day in the purchase period. For example, the purchase period of YourCompany.com runs from January 1 to December 31. If you sell the shares you purchased during the 1998 purchase period on January 15, 2001, you'll get long term treatment for gains because your holding period would be one year and 15 days.
The other factor that determines if you'll get favorable capital gain treatment is whether the sale transaction is a qualifying disposition or a non-qualifying disposition. Whether or not the sale is qualifying depends upon the plan's offering period and how long you have held the shares before selling them.
When you sell ESPP shares you will usually have a capital gain or loss. However, you may avoid gain or loss if you sell the shares immediately upon receiving them and your cost basis (the purchase price plus your discount on the shares) equals the current stock price.
The capital gain will be long term or short term based on whether the disposition is a qualifying disposition or a disqualifying disposition.
A qualifying disposition of ESPP shares is when you dispose of the stock held more than one year from the date of purchase of ESPP shares and two years from the date of the beginning of the applicable ESPP offering period. For a qualifying disposition of stock, capital gain (or loss) will be long term.
A disqualifying disposition of ESPP shares happens when you dispose of stock that you've held either (1) less than two years from the beginning of the ESPP offering period or (2) less than one year from the date of purchase. If you have a disqualifying disposition of stock, your capital gain is considered short term and taxed at your ordinary income tax rate.
Tips Disclaimer
These tips contain information that may change over time as a result of new tax legislation. Although we make efforts to keep this information current, you should check with your tax advisor before taking action based upon any information contained in these tips.