This post explains the wealth-creation benefits of participating in an employee stock purchase plan (ESPP). These plans are an employee benefit available at many companies that have issued publicly traded stock.
Executive Summary
If a company offers an employee discount, employees pay tax at ordinary income tax rates on the discount amount when shares are purchased, and capital gain upon the sale of the shares. The amount of the employee discount, or the difference between the price paid and the fair market value on the date of purchase, will be included on your W-2 if you’re a company employee. When you sell the shares, the capital gain may be taxed at the lower long-term capital gain rate, depending upon how long you held the shares. A common mistake made after selling ESPP shares occurs when the sale is reported on your tax return: include the employee discount amount shown your W-2 to the amount paid for the stock when calculating cost basis and gain.
How an ESPP Plan Works
If your employer offers an ESPP, you can generally purchase company stock at a discount from the stock’s fair market value. Usually, the discount allows you to buy the stock at 85% of the value. In addition, you’ll benefit from a rising stock price if your plan allows you to buy the shares at the 15% discount at the lower of the beginning or end of the ESPP offering period.
Tax Treatment
The basic tax consequence of an ESPP transaction 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 gain may be taxed at the lower long-term rate, depending upon how long you held the shares.
Determining whether you are eligible for long-term capital gain treatment on ESPP sales depends on several factors. 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 for at least one year and one day beyond the last day in the purchase period. 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 held the shares before selling them. The capital gain will be long-term if it’s a qualifying disposition, or short-term if it’s a disqualifying disposition.
A disposition considered qualifying when you dispose of 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 less than two years from the beginning of the ESPP offering period, or 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.
Tax Trap
A common mistake many people make when they sell ESPP shares and need to figure out their cost basis is forgetting to add the amount that was included in their W-2 to the amount they paid for the stock. The amount included in your W-2 is considered part of cost basis. When you add the amount included in your W-2 to your cost basis, your capital gain and corresponding tax liability are reduced.
Definitions
Here are some definitions and descriptions to help you understand and analyze your ESPP plan:
- The enrollment date is the first day of the offering period (also called the subscription period) for which you can make stock purchases.
- The exercise date is the last day of the purchase period.
- In many ESPP plans, your purchase price is based on the lower of the stock’s price at the beginning or the end of the offering period. If the price rises throughout the period, your purchase price is based on the beginning of the period price. For example, at the beginning of the subscription period, the shares traded at $90. At the end of the period, the shares traded at $99. The price you’ll pay for the shares is $90.
- The purchase period is a window of time and depends on your company’s plan. Many companies have a six-month 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 how the ESPP plan works. It’s a good idea to get a copy of your employer’s ESPP plan document for reference.
- You are deemed to have earned income for the amount of any purchase discount. Many companies give a 15% discount on the purchase of shares; your W-2 should reflect this discount.
- When preparing your tax return, include in cost basis the amount of any discount. In the above example, for instance, you’re able to purchase company’s shares currently trading at $99 for $90. The $13.50 discount (15% of $90) is income to you, and you will be subject to tax on this amount. Your company should include the discount value 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.
Planning with ESPP Shares
We generally recommend participating the ESPP plan and immediately selling the shares when you receive them. (If you have a 10b5-1 plan available, include the ESPP shares in it.) Although any gain will be taxed at the higher short-term rates, you’ll realize the 15% discount regardless of what the stock price does down the line. Plus, if the share price drops in the future and you continue to participate in the ESPP plan, you’ll buy more stock at lower prices.
Conclusion
Enrolling in the ESPP plan is a good move for most people—it’s as if you got a 15% bonus, plus an additional bonus on a rising stock price if your plan allows for this. Just be sure to sell the shares as soon as possible, and include the total price you paid, including the share price and the discount included on your W-2, to keep your capital gain tax low.
