Tax rules for the sale of employee stock purchase plan (ESPP) shares can be quite complex for plans that allow participants to purchase stock at a discount. The best way to explain the rules of the road for dealing with ESPP stock purchases and sales is through examples, to help ESPP participants better understand the nuances of these plans. Our fictional sample ESPP participant is Jim Brook of Orange, Inc. We'll see how Jim's shares can be sold in several ways, and what happens in each scenario.
First, the sale of the stock can trigger a combination of capital gain (or loss) and compensation income. A common pitfall for the unwary is a sale that triggers both compensation income (taxed at ordinary income tax rates) and a capital loss (of which only up to $3,000 may be used to offset ordinary income). The degree to which these come into play depends on a number of factors, including:
- Whether or not certain holding periods are met.
- The price of the stock at the time of sale.
- The price of the stock, based on several specific key dates.
Key Dates and Stock Price
There are several dates that play an important role in calculating the tax implications of the sale of ESPP stock:
- The date of sale (or other disposition) of stock and the price at the time of sale.
- The date of the beginning of the subscription period and the corresponding stock price.
- The date the stock was purchased (acquired) and the corresponding market price of the stock.
- In addition to the point above, you’ll also need to know the actual price per share paid for the stock (e.g., the discounted price) on the date of acquisition by the ESPP participant.
The impact of each of these factors will vary depending on whether the sale is qualified or not and whether the stock is sold at a gain or a loss. (For more, see: Portfolio Returns: What's Reasonable to Expect?)
Key Tax Form for ESPP Stock
See IRS Form 3922 titled: “Transfer of stock acquired through an Employee Stock Purchase Plan under Section 423(c).” This form is issued to you by your employer when you acquire stock purchased under an ESPP at less than 100% of fair market value (e.g., at a discount). This form identifies the important metrics you’ll need to know in order to correctly calculate gains and losses when the stock is eventually sold.
- Box 1: Date option granted
- Box 2: Date option exercised
- Box 3: Fair market value (FMV) per share on grant date
- Box 4: Fair market value per share on exercise date
- Box 5: Exercise price paid per share
- Box 6: Number of shares transferred
- Box 7: Date legal title transferred (to you)
- Box 8: Exercise price per share determined as if the option was exercised on the date shown in box 1 (date option granted).
Qualifying Holding Periods
There are two holding periods that need to be considered for ESPP stock to determine whether a sale of stock is considered to be qualified or disqualified.
- The stock was held for at least two years from the date the option was granted. This is the date that corresponds to the beginning of the subscription period.
- The stock was held for at least one year from the purchase date.
If both of these conditions are met, then the sale is a qualified sale. If not, the sale is a disqualified sale. (For more, see: Don’t Buy What You Don’t Understand.)
If at the time of the sale of the stock the sale does not meet the two criteria needed for a qualified sale, then the sale is a disqualified sale and the consequences are as follows:
- The bargain element (the difference between the fair market value of the stock on the actual date of purchase and the purchase price paid for the stock) is taxed as compensation income.
- The cost basis for the stock is the fair market value on the date of purchase.
- Capital gain or loss is based on the increase or decrease in value between the cost basis and the sale price.
- The holding period for determining whether the gain or loss is short term or long term depends on the time period between the purchase date and the sale date.
To better understand how this works let’s consider Jim Brook, an Orange employee. Jim decides to participate in his company’s ESPP plan. The plan has a six-month subscription period and allows employees to purchase stock at a 15% discount to the lower of the stock price at either the beginning or the end of the subscription period.
- Jim subscribes to the ORNG ESPP on January 1, 2015. The subscription period lasts for six months and ends on June 30, 2015.
- At the beginning of the period, ORNG trades at $107.35.
- At the end of the period, ORNG trades at $124.86.
The ORNG plan allows Jim to buy stock at a 15% discount to the lower of the prices at the beginning and end of the subscription period, so Jim pays $91.25 per share for his ORNG shares (85% of the lower of the beginning and end prices, which in this example is the price at the beginning of the subscription period: $107.35). (For related reading, see: Where Do Investment Returns Come From?)
Just the Start
The rules that govern employee stock purchase plans are complex and require attention to detail. Besides key dates, tax forms, holding periods and disqualified sales criteria, employees who participate in ESPPs will also need to learn the nuances of a qualified sale, what happens when the company stock price drops, and understand some special situations when a disqualified sale of ESPP shares might be beneficial. I'll cover all of these topics in my next article, so stay tuned. (For related reading, see: Turn Retirement Cash Flow Into Your Own Paycheck.)