Taxation of Employee Stock Purchase Plans - Part 1
Today we are going to talk in a bit more detail about the taxation of ESPPs, better known as Employee Stock Purchase Plans. I’ve mentioned before that ESPPs are my favorite form of equity compensation. This is for a few reasons.
Before I jump into the reasons, just a quick reminder of what an ESPP is. In its simplest form, Employee Stock Purchase Plans allow employees to purchase company stock.
One reason I love ESPP is because it is so easy to participate. You buy company stock through payroll deduction. Just like contributing to your 401k, ESPP participation is simple to set up and execute.
Next, most plans offer a discount on the stock purchased through the ESPP. The maximum discount allowed is 15% and most employers go to this maximum discount.
A final reason is because just about every full-time employee of the company can participate. This is unlike Restricted Stock Units, Awards, and Stock Options which can be limited to certain employees. Oh, and I need to mention the maximum ESPP amount you can buy this year is $25,000.
Now, I did an early podcast episode focusing just on ESPPs. I believe it is episode 7. You may want to go back and listen to that episode for general details on Employee Stock Purchase Plans. Please overlook any audio issues. It was an early episode and some of those sound a bit echoey.
While it is easy to participate in an ESPP and acquire that company stock, the taxation of ESPPs can be much more complex. Just like accumulating assets for retirement is relatively straightforward, the distribution of those retirement assets, including ESPPs, has to be treated properly in order to make them last longer and not get hit with higher than normal tax bills. So, let’s talk about taxes and ESPPs.
To get into taxes, we first need to know which form an ESPP takes. ESPPs can take one of two forms – Qualified or Nonqualified. Qualified plans are more common, but nonqualified are simpler. How about we start with the simpler version first.
There is no special tax treatment for nonqualified ESPPs. If you pay full price for the shares in this type of plan they are treated identically to if you bought them in the stock market. Nothing to report and gains and losses are treated like capital gains or losses. If you paid less to acquire the shares than their actual value at the time of purchase this difference is treated as compensation income. This compensation income will be reported as wages on your W-2 and there will be withholdings.
For qualified ESPPs there is nothing to report when acquiring the stock, even if you bought it at a discount. Additionally, there is no income on your tax return and no AMT either. Your employer will provide you a Form 3922 for the year of the ESPP stock purchase, but you don’t do anything with the form until you dispose of the shares. So, keep it in a safe place because there are some odd rules that then come into play.
Qualified ESPPs are often called 423 Plans. This simply refers to the section of the IRS code permitting ESPPs to be tax-qualified. Not too creative, right.
HOLDING PERIODS
A critically important bit of information to know about your tax-qualified ESPP is your Holding Period. The tax treatment of a sale depends on how long you hold the shares. The holding period requirement is met on the later of the following two dates:
- The date two years after the company granted the option.
- The date one year after you received/purchased the stock.
We’re going to break this into two main scenarios. You did not meet the holding requirement and for scenario two, you guessed it, you met the holding requirement.
So, you dispose of the company shares before you met the holding requirement of two years from the grant or offer date, and one year from when you purchased the ESPP stock. This is technically referred to as a “disqualifying disposition.” Now, I say sell the stock, but other actions like transferring or gifting the stock also come into play. These all also qualify as disqualifying dispositions. Fortunately, transferring to a spouse, to a broker, as part of a divorce or after your death are exemptions.
Regardless, a disqualifying disposition means you lose some of the tax-favored treatment of this tax-qualified ESPP. When you do not meet the holding period requirements, you are now dealing with ordinary income.
The difference between the fair market value of the stock at the day you purchased it and what you paid for it. Simple example, the company stock traded for $100 a share on the day of your ESPP purchase. You had a 15% discount so you bought it at $85. You then disposed of it before meeting the holding requirements so you add $15 to your ordinary income for taxation purposes. Please note I said it was calculated on the value of the stock on the day you purchased it. Even if your plan says the purchase price is calculated on the first day of the offering period, a disqualifying disposition will look at the individual day of purchase for that share.
Also, the ordinary income happens in the year you sell or otherwise dispose of the ESPP shares. This applies even if the stock drops in value after your purchase and you do not have any actual gain from the sale.
The last thing I want to talk about is about long and short-term capital gains with Employee Stock Purchase Plans. When you sell your shares, the difference between the sale price and the cost basis, which is the value of the stock at purchase, is treated as a capital gain or loss. Here is where people can get tripped up. If you hold ESPP shares for a year it should be considered long-term capital gain. However, if you dispose of the shares after a year but less than two years from when you enrolled in the ESPP and were granted shares, you have both long-term capital gains or losses and also a disqualifying disposition. Fun, right!
Okay, I think that is enough on ESPP taxation right now. I was probably kidding myself thinking I could cover this all in one post. Next time we will talk about taxation when it comes to meeting the holding period requirement. Cross your fingers that it will be more straightforward.
CEDAR POINT AND MIDGES
Your flashback this week is a quick story from my summer working at Cedar Point. I was hired to work on one of the water rides. Unfortunately, when I arrived I found out they were overstaffed so I was moved to another ride. It was the Junior Gemini area of the park. Basically, a few kiddie rides.
I was disappointed at first, but quickly got over it when I realized it was me and about a dozen girls. Back then, certain rides were run by guys and other by girls. I ended up on the Junior Gemini because they were short staffed and I was rideless.
Enough of that background. One of the responsibilities of working on the Junior Gemini was I had to help test ride a couple of the coasters in the back of the park. Short version is if you worked the opening shift on certain rides, you had to report a little bit early and then go help warm up some coasters. For me, that meant the Mine Ride and the Gemini. I did not care for the Mine Ride as I swear it was always going to fall apart. Riding the Gemini was another story.
There were a couple dozen of us that had to be test riders as they warmed up the Gemini in the morning. Don’t ask me why, but it is what they did. It wasn’t a big deal and it certainly woke you up in the morning. Depending on the weather, warmup rides ranged from a couple of close to ten. Usually it was just a couple of turns through. I’ve always loved the Gemini so it was no big deal.
Now, there was a period in there where working on the Junior Gemini came in handy. The crew chiefs for the Junior Gemini had worked at the park for several summers. Because they worked there before they shared with me a huge tip one morning when I had to warm up the Gemini.
Every year during the early part of the summer, Cedar Point gets covered in Midges, Mayflies, Canadian Soldiers, or whatever you wanted to call them. They hatch around the lake and just cover everything, especially at night.
So, one day I was finishing a shift on the Junior Gemini and one of my bosses told me to wear my full rain gear to open the next morning. I asked why. She just said it would help on the Gemini. Next morning came and she told me to wear it, even though it was a beautiful morning. Then, she said once I was in the Gemini car heading up the first hill to flip the hood up, cinch it as tight as I could, and then put my head down. I thought she was crazy, but she told me to trust her. I am glad I did.
What happened during the Mayfly hatch is they nested on the timbers of the Gemini at night. They loved the wood of the Gemini versus the metal of the other coasters. When our test cars would go through in the morning it rattled the beams and the Mayflies woke up, flew off the timbers and we flew through their hoards. I couldn’t tell you how thick it was as I had my head down, but I saw the results.
When we made it back to the station I lifted my head up and came out of my hoody cocoon. Most of my co test riders were picking Mayflies out of hair, mouths, eyes and all over their faces. Remember, this was the summer of 1990 and there was lots of big hair, which apparently doubles as a great bug catcher. There were a handful of us that had good crew chiefs who had advised us to wear raingear. The next morning, every single person had their raingear on.
As always, thanks for taking the time to read this. Please do not hesitate to reach out if I can be of help with your equity compensation-related questions. The easiest thing to do is to click the little green box that reads “Schedule a Meeting” that can be found at the bottom of every page on my website. Or, just click my Calendly link right here.
I’m Dan Johnson, CFP®, founder of Forward Thinking Wealth Management. I run a flat-fee financial planning and investment management firm located in beautiful Akron, OH. Although I am in Akron, OH, I work with clients regardless of location. I cater to owners of equity compensation positions who are looking to organize their financial lives, keep more of what they make, and do the things they want in retirement and even now.