Employee Stock Purchase Plans (ESPP) are a great incentive for companies that want to promote ownership to employees. This widely available benefit directly links employee compensation to the company’s performance. ESPPs are popular because they take advantage of a tax rule that allows an employer to sell company stock at a discount to employees. If you are enrolled in an ESPP, you need to understand what you can do when you receive company stock, the tax implications, as well as how to calculate your taxes in a year you sell the shares.
What are Employee Stock Purchase Plans?
Employee Stock Purchase Plans can be structured as either qualified or nonqualified. Qualified plans, which are the most common plans offered, follow Internal Revenue Service rules laid out in Code Section 423. Nonqualified ESPP plans do not follow these rules, which results in the loss of any tax advantage offered under the qualified plan rules. In a 2011 survey, the National Association of Stock Plan Professional found that over 80% of employee stock purchase plans were qualified.
While nonqualified ESPPs can be structured in any manner the employer choses, most plans will follow the qualified rules explained in this article. Qualified ESPPs are open to any employee who is a plan participant in the company retirement plan. Enrolling in an ESPP gives an employee the ability to purchase company stock during an option period.
When employee stock is purchased during the option period, the employee uses pre-tax money to purchase discounted shares. The employer is allowed to discount the company stock 15% below either the market value of the stock at the time the option is granted or when exercised. The discount can be higher than 15% depending on when the option is exercised. After the employee buys these stocks, they can either hold or sell the stock. Before making any decisions, employees need to understand their choices, the tax implications and how to report any stock sale for tax purposes.
Employee Stock Purchase Plan Tax Implications
When it comes to making a decision between holding or selling, employee’s need to know the advantages of either choice. Since ESPP stock is purchased with pre-tax money, there is no taxable event when an employee purchases the shares. Once the stock is sold, there will be taxes owed on any gains. Before selling the stock, employees should first consider how selling shares will impact their taxes. This is especially true when large amounts of shares are being sold or when the employee is in a high tax bracket.
ESPP rules require that holding periods are met in order to receive a favorable tax break. Any sold shares that do not meet the holding period requirements will have more of gains taxes at the potentially higher ordinary income rate. Since the gains are taxed at the employee’s highest marginal tax rate, any sale could potentially push an employee into a higher tax bracket.
An employee’s first option is to sell shares as soon as they are granted. A 15% discount gives an employee a guaranteed 17.6% return on investment. The benefit, besides the return on investment, is that the employee doesn’t face any potential losses if the company stock declines in value after the stock is granted. The downside to immediately selling shares is that the difference between what the employee paid and the fair market value when the option is exercised is treated as ordinary income for that tax year.
The second option is to hold on to company stock. There are many reasons for holding on to investments purchased in an ESPP. An employee may not need the cash, they could be anticipating that the shares will grow in value, or they may wish to defer any ordinary income to a different tax year. If tax implications are the employee’s primary concern, they need to understand how the ESPPs will be taxed.
The tax situation is dependent on how long the employee holds on to the company stock. Stock purchased in an Employee Stock Purchase Plans are subject to holding period requirements that differ from other capital gain rules. In order to satisfy the holding period requirements, stock purchased in an ESPP must not be sold within two years after the grant of the option nor within one year of the purchase.
If the employee satisfies these holding requirements, the sale will receive favorable tax treatment. The amount of gain between the option price and the value of when the option was granted is considered ordinary income. Any amount above that is taxed at the capital gain rate. Not meeting the holding requirement shifts more of the gain into the ordinary income category. The amount that is calculated as ordinary income becomes based on the difference between when the option was granted and when the shares are sold.
The examples below will help illustrate the tax differences between holding the employee stock long enough to meet the requirements and selling prior to that time. Other tax considerations when selling shares are the treatment of losses and the Alternative Minimum Tax (AMT). Any loss from the sale of the stock will be considered a capital loss. Sale of stock purchased in an ESPP are considered “preference items” for AMT rules. Consultation with your tax or financial advisor is your best option if you wish to avoid AMT taxes.
Examples of the Tax Consequences
Let’s look at two examples to illustrate how a sale of stock would be taxed. The first example will show the tax for an employee who held shares long enough to meet the holding period requirements. The other example will show the tax situated under a sale prior to meeting the holding period. In the example, XYZ Corporation grants an option to buy 100 shares January 1st, 2014. The value of the stock is $35 at the time and the company is offering employees the option to buy shares for $29.75.
Employee Stock Purchase Plan Meets Holding Requirement
Employee A decides to purchase the 100 shares the company offered on June 1st, 2015. At the time the option is exercised, the stock is trading for $40 a share. The employee sells the stock for $55 a share on November 1st, 2016. The time between when the option was granted and when the stock sold was 35 months, which meets the two-year holding requirement based on when the option was granted. The stock was held for 17 months after it was purchased, which meets the one-year holding requirement.
When the holding period is met for this example, the ordinary income is $5.25 per share. The amount above that, which is $20 per share, will be taxed at the capital gain rate. Here is how the sale breaks down:
| Date | Year | Event | Price |
| January 1st | 2014 | Option Granted | $29.75 |
| January 1st | 2014 | Fair Market Value | $35.00 |
| June 1st | 2015 | Option Excised | $40.00 |
| November 1st | 2016 | Stock Sold | $55.00 |
| Sale Price (100 shares x $55.00) | $5,500 |
| Purchase Price (100 shares x $29.75) | -$2,975 |
| Gain | $2,525 |
| Ordinary Income ((100 shares x $35.00) – $2,975)) | $525 |
| Capital Gain ($2,525 – $525) | $2,000 |
Employee Stock Purchase Plan Does Not Meet Holding Requirement
Employee B also purchases the 100 shares on June 1st, 2015. However, employee B sells the stock on January 2nd, 2016 for $53 a share. While the employee sold shares after the two-year period from the grant of the option, they did not hold the stock for over a year. Since the holding period has not been met, ordinary income will be $10.25 per share. The amount considered capital gain to $15 per share.
| Date | Year | Event | Price |
| January 1st | 2014 | Option Granted | $29.75 |
| January 1st | 2014 | Fair Market Value | $35.00 |
| June 1st | 2015 | Option Excised | $40.00 |
| January 2nd | 2016 | Stock Sold | $53.00 |
| Sale Price (100 shares x $55.00) | $5,500 |
| Purchase Price (100 shares x $29.75) | -$2,975 |
| Gain | $2,525 |
| Ordinary Income ((100 shares x $40.00) – $2,975)) | $1,025 |
| Capital Gain ($2,525 – $1,025) | $1,500 |
How to report Employee Stock Purchase Plan Gains or Losses
If you are enrolled in an ESPP, your employee will provide you with a Form 3922 “Transfer of Stock Acquired Through an Employee Stock Purchase Plan Under Section 423” for the tax year the purchase is made. This informational form is needed to calculate the cost basis of your stock, so it is important to hold on to. In the tax year that the stock is sold, the sale will be reported on Form 1099-B “Proceeds From Broker and Barter Exchange Transactions.”
In my experience preparing taxes for clients, I have seen some 1099-B forms fully reported breakdowns of the cost basis. Other forms reported only sales proceeds. If you need to calculate the cost basis on your own, you’ll need to know the date and share prices for when the option was granted, when the option was exercised, and the price per share of the sale. After determining if the holding period was met, you would follow the math provided above to determine to report as ordinary income or a capital gain.
Disclaimer: The information provided is not intended to be legal or tax advice. Every business situation is different, and IRS tax rules change annually. Consult with you tax and legal advisors before making any business decisions.Phoenician Financial Planning, LLC offers business tax planning consultation services.