Employee Stock Purchase Plans

An overview of the tax treatment of employee stock purchase plans

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General Overview of Employee Stock Purchase Plans

An employee stock purchase plan (ESPP) is a type of fringe benefit offered to employees of a business. Under the plan, 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 plan (that is, 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 goes through four phases: grant, offering period, transfer, disposition.

Grant phase

The employer grants its employees the option to purchase stock in the employer's 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 paycheck. These payroll deductions occur on an after-tax basis. This means that income tax and FICA taxes 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 Form 3922, one copy to the employee and another copy to the IRS, to document information relating to the transfer of the shares.

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

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. There will be tax impacts in the future, when you sell or otherwise dispose of the ESPP 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 the person has been owned the stock
  • The selling price
  • How many shares are sold

These last two factors determine the amount of 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. Selling price also factors into calculations of compensation income, which we will discuss below.

How long a person has owned the shares determines how the sales transaction is categorized. How the transaction is categorized in turn determines the tax treatment.

There are two holding periods:

  • From the grant date to the day sold
  • From the transfer date to the day sold

Holding Periods Determine How Income is Measured and Taxed

Selling ESPP shares is categorized twice. We categorize each sale of ESPP shares as either qualifying or non-qualifying dispositions; and as either short-term or long-term gain.

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

  • more than one year after the date of transfer and
  • more than two years after the date the options were granted.

(The transfer date is shown in box 7 of Form 3922; the grant date, in box 1 of Form 3922.)

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 before and up to one year after the transfer date or before and up to two years after the grant date.

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.) [2]

A short-term sale is any sale where the person owned the stock for one year or less.

We can express these holding periods using math short hand like this:

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

Now let's put together the story so far and see where this leads us in terms of tax treatment. An employee works for a company. The company set up an ESPP. The employee had money deducted (after taxes) from each paycheck, and that money was used to buy shares in the company's stock.  Now the employee sells the stock.

At this point in the story, we need to make some distinctions. Did the employee purchase stock at a discount? That discount is picked up as compensation income when the shares are sold. The rest the increase (or decrease) in value of the shares is capital gains income. This has a whole host of implications. Right now we are going to focus on just one aspect: that's how to measure compensation income.

Here's what I mean: let's say our client acquires 1 share of XYZ stock for $85. On that day, XYZ stock was worth $100 per share. The employee got a 15% discount on the purchase price. Now he sells his 1 share of XYZ for $125. Overall, our client earns $40 on this investment: the $125 he sold the stock for minus the $85 he paid for the stock. What we do now is separate this $40 income into two components: compensation income and capital gains.

How is compensation income measured? We have three formulas. Do you need to know this? Yes and here's why. I've seen brokerage houses report the wrong basis on the Form 1099-B. Sometimes they get it right. Sometimes they get it wrong. If you know the compensation income, then you can get an accurate calculation of basis. And then you'll be in a position to put the right numbers on your tax return.

There are three formulas for measuring compensation income. Which formulas we use depends on whether we have a qualifying disposition or a non-qualifying disposition.

For qualifying dispositions, compensation income is the lower of:

A. The fair market value of the stock on the date the option was granted, minus the price paid to exercise the option.

B. The fair market value of the stock on the date the stock was sold, minus the price paid to exercise the option.

For non-qualifying dispositions, compensation income is:

C. Fair market value of the stock on the date the option was exercised, minus the price paid to exercise the option.

Fortunately, we don't have to go digging for this information. 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.

What information is not found on Form 3922? The fair market value on the date the client sold the stock. That's because Form 3922 is prepared and issued when the ESPP shares are transferred to the employee, which is needed for formula B, above. The fair market value of the stock on the date sold is going to show up on the Form 1099-B from the brokerage.

So this would be a good time to get familiar with this form.

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.

Form 3922 contains the following data fields:

Box 1

Date option granted

Box 2

Date option exercised

Box 3

Fair market value per share on the grant date

Box 4

Fair market value per share on the exercise date

Box 5

Exercise price paid per share

Box 6

Number of shares transferred

Box 7

Date legal title transferred

Box 8

Exercise price per share determined as if the option was exercised on the date shown in box 1 (the grant date)

 

Form 3922 has the information we need to calculate a person's compensation income, basis, and qualifying holding period in the ESPP shares. I'll give you the relevant math for doing these calculations. The only piece of information that Form 3922 does not have is the selling price for the ESPP shares.

I'll give you the math in abbreviated form here. Then we'll spell out the details and implications later on.

Basic ESPP Math using Form 3922

Holding period calculations

The date the ESPP shares turn from non-qualifying to qualifying

(Box 7) + 1 year

(Box 1) + 2 years

(whichever date is later)

The date the ESPP shares turn from sort-term to long-term gains

(Box 7) + 1 year + 1 day

3 different compensation income calculations

Compensation income on qualifying disposition, lower of:

(Box 3) – (Box 5) * (Box 6)

Or:

((FMV per share at disposition) – (Box 5)) * (Box 6)

Compensation income on non-qualifying disposition

((Box 4) – (Box 5)) * (Box 6)

Basis

((Box 5)*(Box 6)) + compensation income + commissions and fees to buy and sell the stock

 

 

 

The Tax Impact of Qualifying Dispositions

If the employee purchased the stock the stock at a discount, then we measure how much the compensation income is.

We calculate compensation income using equations A and B, above. Whichever answer is lower is the amount of compensation income. Compensation income is taxed as the ordinary tax rates, which currently range from 10% to 39.6%.

Then we measure the capital gain or loss. Gain is the difference between the proceeds you got from selling the stock and your basis in the stock. Basis is the amount originally paid for the stock (the option price) plus compensation income plus commissions and fees paid to buy and to sell the stock. In other words,

  • Gross proceeds – option price – compensation income – commissions and fees = capital gain or loss

If the employee paid full price for the stock, we measure the gain or loss. There is no compensation income, because the employee didn't get a discount on the purchase price. We calculate gain or loss as above. But since compensation income is zero, the formula simplifies to 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 3.9% surtax on investment income.

The Tax Impact of Non-Qualifying Dispositions

If the employee purchased the stock the stock at a discount, then we measure how much the compensation income is.

We calculate compensation income using equation C, above. Compensation income is taxed as the ordinary tax rates, which currently range from 10% to 39.6%.

Then we measure the capital gain or loss. Gain is the difference between the proceeds you got from selling the stock and your basis in the stock. Basis is the amount originally paid for the stock (the option price) plus compensation income plus commissions and fees paid to buy and to sell the stock. In other words,

  • Gross proceeds – option price – compensation income – commissions and fees = capital gain or loss

What Compensation Income Means

The increase in value in the ESPP shares is separated into compensation income and capital gain.

Compensation income is taxed as additional wages the ordinary income tax rates, which currently range from 10% to 39.6%. Compensation income is add to your wages and reported on Form W-2. Compensation income is subject to the federal income tax (and any state income taxes). Compensation income is not subject to Social Security and Medicare taxes ("FICA"). Compensation income is included in the wages reported in Box 1 of Form W-2. Compensation income is not included in the Box 3 or Box 5 wage amounts.

Let's look at this same tax treatment from the perspective of procedure. The previous paragraph tells us how compensation is treated in a conceptual manner. Here's how it plays out in real life. You go to sell some ESPP shares. You log into your broker's web site, and put in a sale order. The broker handles the deal, exchanging some of your shares for cash. The broker and your employer collaborate on the reporting side of things. Their accountants do some math. They now know all the data needed: your selling price, your compensation income, your option cost, your basis, your holding periods, and whether the transaction is qualifying or non-qualifying, and whether they are short-term or long-term. The accountants get to work and figure all this out. You get the cash in your brokerage account. And some of the income gets added to your wages. (But your paycheck doesn't go up, remember you already got the cash in your brokerage account.) So for reporting purposes, this amount is added to you paycheck. And for reporting purposes, the broker reports the transaction and the income on a Form 1099-B. So at the end of the year, you'll need to bring these two reports together to make sure the income is taxed only once, and in the right way.

Getting ESPPs onto the Tax Return

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

Second, calculate basis, also from scratch. Calculate the original basis (what the client paid for the stock). Then the adjusted basis with the compensation income added in (and of course, 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.

Funny story. This year I saw one broker get the basis both right and wrong on the same 1099. There were two transactions on the 1099-B. Each showed basis. The first transaction had the "original" basis (which needed to be adjusted for the compensation income). And the second transaction had the true and correct basis (which didn't need adjustments).

Participating in an ESPP plan carries significant administrative duties for you and your accountant. It is in your best interest to all your ESPP documents so you and your accountant can make sure the numbers are reported accurately.

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