How a Qualifying Disposition Impacts Your Qualified ESPP

A qualified Section 423 employee stock purchase plan (ESPP) provides 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. 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 cheaper price than what you would pay in a typical open market purchase.

Your purchased stock shares are transferred to an individual investment account. Because of this, tax is an important consideration when you have an ESPP. Unfortunately, figuring out the tax rules for ESPPs may not be particularly easy.

Depending on how long you hold 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 tax. Here’s how to sift through the details to better understand your potential federal tax obligations. State and local taxes may vary. 

1. ESPP Tax at Purchase

When you purchase shares via an ESPP, typically no tax is due and no tax is reported. It’s as if you purchased shares on the open market. (Sorry, Pennsylvania—your state doesn’t recognize the federal tax treatment of Section 423 ESPPs and treats purchases similar to that of a non-qualified stock purchase plan. The tax consequences in other states may vary as well.)

Even if the shares are purchased at a discount from the current market price, no tax is generally due at purchase. The purchase of shares through an ESPP is not a reportable event for federal 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 the potential tax you’ll 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).

2. Tax for a Disqualifying Disposition of ESPP Shares

Special holding periods dictate whether proceeds on the sale of ESPP shares are treated as compensation income or capital gains or losses. The length of time you hold the shares after the ESPP purchase, as well as other requirements determines whether a subsequent sale is deemed a qualifying disposition or a disqualifying disposition.

A qualifying disposition of ESPP shares is one that meets both of the following standards:

• The stock must be held for more than one year after the original purchase date

 

• The stock must be held for more than two years after the original offer date

 

Any sale that doesn’t meet these criteria, as well as other requirements is a disqualifying disposition of ESPP shares.

From a tax standpoint, there are generally two things to consider when determining what tax may be owed:

• Portion of the proceeds that will be taxed as compensation income, and

 

• Portion of the proceeds that will be taxed as a capital asset (short-term or long-term capital gains or losses) 

 

3. How This Works in the Real World

These rules are good to know—but how do they actually function? A quick example can help illustrate.

Let’s assume you purchase shares of stock through an ESPP with a 15% discount. The price at the beginning of the offering period was $20 per share and at the end of the offering period, it’s $25 per share. That means you can buy shares of the company at $17 per share, a 15% discount from $20 per share (the lower of the two assuming your company provides a lookback provision).

Now, let’s say you eventually sell your shares (assuming a disqualifying disposition—i.e., didn’t meet the holding requirements) 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 allocated for tax purposes?

Because this is a disqualifying disposition, you report compensation income on the amount of the price of the stock at the end of the offering period ($25) minus the discounted purchase price ($17), or $8 per share. This increases the basis of the stock to $25.

The final sales price ($30 per share) less the cost basis ($25) equals the amount treated as a capital gain ($5). Assuming less than a one-year holding period, a short-term capital gain is taxed as ordinary income. 

4. What Happens If Your Share Price Falls After the Purchase?

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 earned ordinary 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 need to report compensation income on the spread between the discounted purchase price ($17) and the price at the end of the offering period ($25), or $8 per share.

Your cost basis again increases 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.

5. Tax for a Qualifying Disposition of ESPP Shares

If you meet the requirements for a qualifying disposition, you will likely report both compensation income and long-term capital gain income.

Let’s hypothetically assume that you purchase shares of stock through an ESPP with a 15% discount. 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 per 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 estimated after-tax impact using simple tax assumptions (33% for compensation income and short-term capital gains, and 15% for long-term capital gains), we can illustrate a potential benefit of a qualifying disposition:

Disqualifying Disposition

• $30 sales price

 

• $13 per share gain

 

• 33% tax on $13 = $4.29

 

• After tax gain per share = $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 gain per share = $10.51

 

In this hypothetical example, a qualifying disposition resulted in $1.80 per share additional gain, or nearly 20% more. 

Final Thoughts on ESPP Taxes

The above scenarios illustrate a possible outcome for an ESPP. However, there are many other scenarios that could impact the outcome of your actual plan and those should be considered as well.

Regardless, an ESPP may be a great way to participate in your company’s potential growth through the purchase of company stock. In many cases, participating in an ESPP may be a good option to include in your overall financial plan.

For advice on your personal financial situation, please consult a tax advisor.