Employee Stock Purchase Plans

An overview of the tax treatment of employee stock purchase plans

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An employee stock purchase plan (ESPP) is a type of fringe benefit offered to employees of a business. Under these types of plans, the business grants its employees the option to purchase the company's stock using after-tax deductions from their pay.

The plan can specify that the price employees pay per share is less than the stock's fair market value. A qualified ESPP (one that meets all the rules laid out in ​section 423 of the Internal Revenue Code) can offer discounts of up to 15% on the purchase price of the stock.

ESPPs generally go through four phases: grant, offering period, transfer, and disposition. ESPPs are designed to use after-tax earned income for purchasing a stock. Taxes are then collected on the income when you sell the stock and realize the gains. Knowing the lingo and understanding how to include the gains in your taxes can help you determine if ESPPs are a good option for you.

Grant Phase

The employer grants its employees the option to purchase stock in the company (or parent company) at a predetermined price.

Offering Period

The offering period is the time during which employees accumulate savings for the future purchase of the company's stock. Employees choose to have a percentage or fixed dollar amount deducted from each of their paychecks.

These payroll deductions occur on an after-tax basis. This means that income tax and Federal Insurance Contributions Act (FICA)—Social Security and Medicare withholding—have already been taken out of your pay before the money is set aside for ESPP purchases.

Transfer Phase

At the end of the offering period, the employer takes all the money that has been saved up and uses that money to purchase shares of the company's stock.

The securities brokerage administering the ESPP plan will purchase shares of the company's stock and transfer ownership of the stock to the participating employees. Any cash not used to purchase stock is refunded back to the employee.

Along with transferring ownership of the shares, the company issues documents to its employees. The company sends two copies of Form 3922—one to the employee and another to the IRS—to document information relating to the transfer of the shares.

The brokerage house administering the ESPP will also send you a trade confirmation.

The company sets up brokerage accounts for participating employees, and the shares purchased under the ESPP are deposited there. There is no tax impact when the shares are purchased and transferred to you; however, there are tax implications when you sell the shares.

Disposition Phase

After the shares are transferred into your name, you are free to do with them as you please. You may sell, trade, exchange, transfer or give them away. Disposing of ESPP shares triggers tax impacts. The tax impact depends on three factors:

  • How long you have owned the stock
  • The selling price
  • How many shares are sold

The selling price and the number of shares sold determine the amount of income or compensation income a person earns from the sale of the stock. Selling price multiplied by the number of shares sold results in the gross proceeds from the sales transaction. Compensation income is the difference in the amount a share was purchased for and the market value of the share.

Gross Proceeds = Sales Price * Number of Shares Sold

The length of time a person has owned shares determines how the sales transaction is categorized. The category, in turn, determines the tax treatment—along with the holding periods.

Holding Periods

There are two holding periods that dictate a transaction's classification. One period is from the grant date to the day sold; the other is from the transfer date to the day sold. The disposition of the stocks is further broken down into qualifying or non-qualifying transactions.

The two holding periods are the grant date to the day sold, or the transfer date to the day sold.

Selling ESPP shares is categorized twice—first, each sale of ESPP shares is either a qualifying or a non-qualifying disposition. Second, as either a short-term or long-term sale.

Qualifying Disposition

A qualifying disposition is any sale or transfer of ownership of the ESPP shares after the person has held the stock for both:

  • More than one year after the date of transfer
  • More than two years after the date the options were granted

Non-Qualifying Disposition

A non-qualifying disposition is any sale or transfer of ownership of the ESPP shares that don't satisfy the qualifying disposition criteria spelled out above. In other words, non-qualifying dispositions are sales of ESPP shares that occur both:

  • Before and up to one year after the transfer date or before
  • Up to two years after the grant date

Long- and Short-Term Sale

A long-term sale is any sale where the person owned the stock for more than one year. The holding period for determining whether a stock is long- or short-term begins from the day after the stock is purchased and ends on the date of sale.

A short-term sale is any sale where the person owned the stock for one year or less. Refer to the following table to determine length and disposition.

Qualifying disposition if

Sale date > 1 year after transfer date AND
Sale date > 2 years after grant date

Non-qualifying disposition if

Sale date ≤ 1 year after transfer date OR
Sale date ≤ 2 years after grant date

Long-term rates apply to the capital gains if

Sale date > 1 year + 1 day after transfer date

Ordinary rates apply to short-term capital gains if

Sale date ≤ 1 year after transfer date

Separating Compensation Income from Capital Gains Income

There are considerations to be made when determining whether income is compensatory or a capital gain. For example, a company sets up an ESPP, and an employee purchased a stock. The employee had money deducted (after taxes) from each paycheck, using the money to buy shares in the company's stock—and then sold it a few months later. 

This is where some distinctions have to be made. If the employee purchased the stock at a discount, the discount is counted as compensation income when the shares are sold. The increase or decrease in the value of the shares is counted as capital gains income. While this has a whole host of implications, it's important to know how to measure compensation income.

For instance, an employee acquired one share of XYZ stock for $85. On that day, XYZ stock was worth $100 per share. Since the purchase price was less than the market value, there was a 15% discount. If they were to sell their one share of XYZ for $125, they earn $40 on this investment—the sale price of $125, minus $85 paid for the stock. This $40 of income is separated into two components: compensation income and capital gains.

In this case, compensation income is the dollar amount of income an employee saved by purchasing a stock at a discount.

If you know the compensation income, then you can get an accurate calculation of basis (the amount originally paid for the stock). Then you'll be in a position to put the right numbers on your tax return.

There are three formulas for measuring compensation income. The formulas used depend on whether there is a qualifying disposition or a non-qualifying disposition.

The first formula takes the fair market value (FMV) of the stock on the date the option was granted (dg) and subtracts the price paid to exercise the option (P).

FMVdg - P

The second one takes the fair market value of the stock on the date the stock was sold (ds) and subtracts the price paid to exercise the option.

FMVds - P

The third formula takes the fair market value of the stock on the date the option was exercised (de) and subtracts the price paid to exercise the option.

FMVde - P

For qualifying dispositions, compensation income is the lower of formula one or two; for non-qualifying dispositions, compensation income is formula three.

Most of this data is found on Form 3922. Employers prepare this form and issue it to their employees whenever stock is transferred under an employee stock purchase plan. However, the fair market value on the date the client sold the stock is not on the form.

This is because Form 3922 is prepared and issued when the ESPP shares are transferred to the employee, which is needed for formula two, above. The fair market value of the stock on the date sold will show up on the Form 1099-B from the brokerage.

Form 1099-B

Working With Form 3922

Form 3922 is titled, "Transfer of Stock Acquired Through an Employee Stock Purchase Plan Under Section 423(c)".

Companies issue Form 3922 to their employees detailing information relating to the transfer of stock under an employee stock purchase plan. Form 3922 contains most of the data points we need to run any calculations relating to the ESPP shares.

IRS Form 3922
IRS Form 3922

Form 3922 has the information needed to calculate a person's compensation income, basis, and qualifying holding period in the ESPP shares. The only piece of information that Form 3922 does not have is the selling price for the ESPP shares.

Basic ESPP Math using Form 3922

Holding period calculations

The determine the date the ESPP shares turn from non-qualifying to qualifying, use the later of two dates:

The Date Legal Title Transferred (Box 7) + One Year, or

The Date Option Granted (Box 1) + Two Years

3 different compensation income calculations

Compensation income on a qualifying disposition is the lower of two formulas: 

Formula one: ( FMV per Share on the Grant Date ( Box 3 ) – Exercise Price Paid per Share ( Box 5 ) * Number of Shares Transferred ( Box 6 ) )  

Formula two: ( ( FMV per Share at Disposition ) – Exercise Price Paid per Share ( Box 5 ) ) * Number of Shares Transferred ( Box 6 ) )

Compensation income on a non-qualifying disposition is calculated by using this formula:

Formula three: ( FMV per Share on Exercise Date ( Box 4 ) – Exercise Price Paid per Share ( Box 5 ) ) * Number of Shares Transferred ( Box 6 )

Basis can be calculated in two ways:

Basis = ( Exercise Price Paid per Share ( Box 5 ) * Number of Shares Transferred ( Box 6 ) ) + Compensation Income + Commissions and Fees to Buy and Sell the Stock, or

Basis = Option Price + Compensation Income + Commissions and Fees

The Tax Impact of Dispositions

Using the formulas above to determine compensation income, the income is taxed using ordinary tax rates, which currently range from 10% to 37%. This is used for both qualifying and non-qualifying dispositions.

Capital Gains

Capital gains or losses are determined in the same manner for qualifying and non-qualifying dispositions. Gain is the difference between the proceeds you received from selling the stock and your basis in the stock:

Capital Gain (Loss) = Gross Proceeds - Basis

If the employee paid the full price for the stock, there is no compensation income, because there was no discount. Gain or loss is calculated as above. But if there is no compensation income, the formula simplifies:

Capital Gain (Loss) = Gross Proceeds – Option Price – Commissions

Gains on long-term holdings are taxed at special long-term capital gains tax rates of 0%, 15%, or 20%. Gains may also be subject to the 3.8% surtax on investment income.

What Compensation Income Means

Compensation income can be loosely defined as all wages or payments you receive for your services. Discounts on shares are included in this category of income, so it is added to your wages and reported on Form W-2; however, it is not subject to FICA.

Compensation income from an ESPP is added to your reported earnings but is not added to your paycheck (because the value is in your brokerage account or the stock itself). For reporting purposes, the broker reports the transaction and the income on a Form 1099-B.

Placing ESPPs On Your Tax Return

First, calculate compensation income from scratch, using all the brokerage statements and tax documents the client provides. Compare your calculation to the amount on your Form W-2.

Second, calculate basis, also from scratch. Calculate the original basis, then calculate the adjusted basis with the compensation income added in (and the brokerage commissions).

Compare these basis figures to those that appear on the Form 1099-B and any supporting brokerage statements. If the Form 1099-B shows only the "original" basis, then put the difference in the adjustment column of Form 8949. If the 1099-B shows the true and correct basis as adjusted for the compensation income, then no adjustment is needed.