This week’s post is going to be super short. At least shorter than last week’s. We are going to continue the conversation about taxation of Employee Stock Purchase Plans. Now, I could try and make this post much longer by reviewing what exactly is an ESPP. However, I am not that guy. Just go back to last week’s post. That covers the basics of Employee Stock Purchase Plans as well as the introduction of taxes.
There are two main items to know with taxation of ESPPS. First, if the plan is Non-Qualified there is not a whole lot to know. I’m being serious about that as the taxation of Nonqualified ESPPs is super straightforward.
Here it is. Company stock purchased through a NQ ESPP is just like buying it through the stock market. That’s it. The only thing to know is if there is a discount you will have that reflected on a W-2 issues by your employer and the discount will be treated as compensation income.
Next main item is if your ESPP is a qualified plan. This is the more common form of Employee Stock Purchase Plans. Qualified plans simply mean they follow certain IRS rules and have favorable tax treatments.
I reviewed the definition of Holding Periods in the previous article. Because it is salient to this one, let’s revisit this definition. 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.
If you dispose of shares before meeting the holding period requirements, you have done what is called a disqualifying disposition. Basically, you lose some or all of the tax benefits of qualified Employee Stock Purchase Plans. Obviously, if you meet the holding period requirements, you then can have what is called a Qualifying Disposition. And that is our focus.
Compensation income, also known as ordinary income, will show up when you dispose, or sell, your ESPP stock. To calculate your ordinary income, it will be the lesser of the gains, which is the difference between what you paid for the shares and what you sold them for, or the purchase price discount. Remember, ESPPs can offer a discount of up to 15% off the share price. Whatever your compensation income comes out to be, it will be reported on a W-2.
Let’s get into some nitty gritty details. Mystockoptions.com is a great resource if you want more information.
When the purchase price is based on the lower value of the stock on either the first day or the last day of the offering period, the purchase price discount for tax purposes is calculated as of the first day of the offering period, though it may be the higher price.
An important note here. Even if your company's ESPP does not have a lookback (i.e. the discount for the purchase price is always taken from the price on the last day of the offering period), to calculate ordinary income you still base the discount on the first day's price.
Back on topic here. All additional gain upon the sale of stock will be treated and taxed as long-term capital gain. If you sell the shares for less than your purchase price, you will not have any ordinary income, and you will have a long-term capital loss for the difference between the sales price and the purchase price.
If you are looking for a great chart showing what I mean, well, pay a visit to mystockoptions.com.
The only other thing to mention with taxation of qualified ESPPs via qualifying disposition is there may actually be rate situations where you should want to do a disqualifying disposition. I won’t get into an example here, but no there are times when this may make sense.
As everything with taxes, be sure to consult your CPA on this topic for your individual situation. Know that taxation of employee stock purchase plans can get complex and quickly. So be sure your CPA is experienced in this area.
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.