Earlier this month we looked at the sale of employee stock purchase plan (ESPP) shares and their complexity, including important dates and tax forms, holding periods and disqualified sales. Now we'll review the rules that govern qualified sales of ESPP shares, and some special circumstances that investors who participate in ESPPs should be prepared for. (For more, see the first article: Tax Tips for Employee Stock Purchase Plans.)
In many cases, qualified sales will offer some tax advantages compared to a disqualifying sale. The calculations involved are a bit more complex, particularly in calculating the bargain element (which is still subject to ordinary compensation tax) and the cost basis of the shares (which impacts the capital gain or loss on the sale).
A qualified sale is one in which both of the qualifying holding period requirements are satisfied. Under a qualified sale, the bargain element is still taxed as compensation income, but is the lesser of:
- Calculation 1: Fair market value (FMV) at disposition minus the amount paid on the actual date of acquisition.
- Calculation 2: The difference between the fair market value of the stock and the discounted purchase price if the purchase of stock had taken place at the beginning of the subscription period.
- Note that even if calculation 1 is less than zero, the bargain element will be zero but not less than zero.
Once the bargain element has been determined, the bargain element (if any) is taxed as compensation income, and the cost basis of the shares becomes the purchase price paid for the shares plus the bargain element. The difference between FMV at sale and cost basis will be treated as a long term capital gain (or loss). (For related reading, see: Where Do Investment Returns Come From?)
If we change the sale date to assume the sale takes place at a point where both criteria for qualifying sales have been met, here’s how the scenario plays out if we assume our example Jim sells his ORNG shares on July 20, 2017 at $130.75.
Jim’s plan entry date is January 1, 2015, and the actual purchase date was June 30, 2015, so a sale on July 20, 2017 means the stock will have been held for two years or more from date of entry and at least one year or more from date of purchase, so the sale is a qualifying sale.
The bargain element calculation is done as follows:
- Calculation 1: Fair market value at disposition ($130.75) minus the amount paid at the actual date of acquisition ($91.25). Calculation 1= $39.50 per share.
- Calculation 2: The amount of the discount if the purchase of the stock had occurred on the beginning date of the subscription period. Since the stock price on January 1 2015 was $107.35 and 85% of that price is $91.25, the bargain element under calculation 2 is $16.10.
In this case, since $16.10 (calculation 2) is less than $39.50, (calculation 1) the bargain element is $16.10 and is reported as compensation income. (For related reading, see: Portfolio Returns: What's Reasonable to Expect?)
Jim’s cost basis becomes $107.35 per share (his actual purchase price of $91.25 plus the bargain element from the computation above). With the sale at $130.75, he realizes a long-term capital gain of $23.40 per share (sale price minus cost basis). Since long-term capital gain tax rates are generally more favorable than ordinary income tax rates, Jim enjoys some advantageous tax benefits when selling his stock at a gain in a qualified sale.
If Stock Price Decreases in a Qualified Sale
In situations where the stock price drops, the participant may also benefit from a qualified sale. Let’s examine the situation where Jim sells his shares on July 20, 2017 at $90.34. Under this scenario, calculation 2 remains the same ($16.10), but calculation 1 now becomes the following:
- FMV at disposition is $90.35, less the amount paid at acquisition: $91.25 = -0.90.
- Since this amount is less than zero, compensation income is zero (but not negative) and the cost basis of the stock becomes $91.25.
- Upon sale of the stock, a long-term capital loss of $0.90 per share is realized.
Special Situations That Warrant Extra Caution
It is useful to sell as a disqualified sale under the following three conditions:
- Stock at the end of the subscription period is less than at the beginning of the period.
- The stock has been held long enough to qualify for long-term capital gain treatment (e.g., one year from purchase but not two years from the beginning of the subscription period).
- The current stock price is higher than the original purchase price.
In this example, due to the bargain element being computed at the start of the subscription period and therefore the higher price, the unqualified sale should result in a lower amount of ordinary income (subscription) and a greater amount of long-term capital gain income than a qualified sale. (For related reading, see: Turn Retirement Cash Flow Into Your Own Paycheck.)
Let’s assume the following situation to see how this differs from our earlier example. Suppose the following fact pattern:
- Jim enrolls in his company’s ESPP program with an entry date of February 1, 2014.
- Employees receive a 15% discount on the purchase price.
- The purchase price is the lower of the price at the beginning or the end of the subscription period.
- The price on February 1, 2014 (beginning of the period) is $100 per share.
- The price on July 31, 2014 (end of subscription period and the purchase date) is $80 per share.
- It is now January 29, 2016 and the price of the stock is $120 per share.
Under this scenario, would Jim be better off selling today or waiting the few extra days to meet the criteria for a qualified sale, assuming the stock price doesn’t materially change?
- Looking first at a disqualified sale, Jim would realize compensation income of $12 per share (the 15% discount from the $80 share price at the end of the subscription period) and a long-term capital gain income of $40 per share.
- Under a qualified sale, Jim would recognize $15 per share in compensation income (representing the 15% discount from the $100 stock price at the beginning of the subscription period – this is calculation 2, which is lower than calculation 1).
- Under a qualified sale, Jim would realize long-term capital gain income of $37 per share.
So all else being equal, in this scenario, Jim would be slightly better off doing a disqualifying disposition. (For related reading, see: Can You Stomach the Perfect Investment?)
Investors should note that a variety of other factors can come into play that may affect the decision, hence the importance of planning for your specific situation and circumstances. I’ve referred to qualified and disqualified sales in this article, but the rules apply to other forms of disposition as well, such as a transfer as a gift or as the result of the death of the holder. Jim’s outcome in this article is not meant to be a “one size fits all” answer.
As illustrated, there are opportunities to help minimize the tax bite, and maximize the benefit of these programs for the plan participants. In doing so, the participant should also consider the big picture. How reliant is your economic and financial health on the health of your company? This question addresses not only the level of exposure your portfolio has to your company stock, but also to your reliance on your salary, medical benefits, insurance coverage, and company retirement plan programs. Taking these factors into consideration will help put the tax consequences of an appropriate stock diversification program into better perspective. (For related reading, see: Why You Should Diversify and Rebalance.)