An employee stock purchase plan (ESPP) is a fringe benefit offered to employees. The business grants its workers an option to purchase the company's stock using after-tax deductions from their pay.
The plan can state that the price workers 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.
Understanding how to include the gains in your tax plan can help you determine if ESPPs are a good option for you.
Four Phases to the Purchase
ESPPs often go through four phases: grant, offering, transfer, and disposition. They're set up to use after-tax earned income for purchases. Taxes are then collected on the income when you sell the stock and realize the gains.
The Grant Phase
The employer grants its workers the option to purchase stock in the company or in a parent company at a set price.
The Offering Period
The offering period is the time during which workers save for the future purchase of the stock. They have a percentage or a fixed dollar amount deducted from each of their paychecks.
These payroll deductions occur on an after-tax basis. Income tax and Federal Insurance Contributions Act (FICA) taxes—Social Security and Medicare—are withheld from your pay before money is set aside for ESPP purchases.
The Transfer Phase
The employer takes all the money that has been saved. It uses it to purchase shares of the company's stock. The securities brokerage that's administering the ESPP plan will purchase the shares. It will then transfer ownership of them to the employees. Any cash that's not used to purchase stock is refunded back to the worker.
The company issues documents to its workers when the shares are transferred. It sends two copies of Form 3922—one to the employee and another to the IRS—to document the transfer of the shares.
The brokerage that's administering the ESPP will also send you a trade confirmation.
The company sets up brokerage accounts for its participating workers. The shares purchased under the ESPP are deposited there. There's no tax impact when the shares are purchased and transferred. But there are tax implications when you sell the shares.
You're free to do as you please with the shares after they're transferred into your name. You can sell, trade, exchange, transfer, or give them away. But disposing of ESPP shares triggers tax impacts that depend on three factors: how long you've owned the stock, the selling price, and how many shares are sold
The selling price and the number of shares sold determine the amount of income you earn from the sale. The selling price multiplied by the number of shares sold results in the gross proceeds from the sale. Compensatory income is the difference between the amount a share was purchased for and its market value.
- Gross proceeds equals sales price times the number of shares sold
The length of time you own the shares determines how the sale is categorized. The category determines the tax treatment, along with the holding periods.
There Are Two Holding Periods
Two holding periods dictate a transaction's classification. One runs 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 then 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. Then it's either a short-term or long-term sale.
A qualifying disposition is any sale or transfer of ESPP shares after the person has held the stock for both more than one year after the date of transfer, and for more than two years after the date the options were granted.
A non-qualifying disposition is any sale or transfer of the ESPP shares that doesn't satisfy the qualifying disposition rules. 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.
Long- and Short-Term Sales
A long-term sale is any sale where you've 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. It ends on the date of sale.
A short-term sale is any sale where the person owned the stock for one year or less.
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
Compensation Income vs. Capital Gains Income
A few factors determine whether income is compensatory or a capital gain. Let's say that a company sets up an ESPP. A worker purchases a stock. The worker had money deducted (after taxes) from each paycheck. They used the money to buy shares. Then they sold the shares a few months later.
The discount is compensation income if the employee purchased the stock at a discount. The increase or decrease in the value of the shares is counted as capital gains income. This has a whole host of implications.
A worker might acquire one share of XYZ stock for $85. This stock was worth $100 per share on that day. The purchase price was less than the market value so there was a 15% discount. They would earn $40 if they were to sell their one share of XYZ for $125: the sale price of $125 minus the $85 paid for the stock. This $40 is separated into compensation income and capital gains.
Compensation income is the dollar amount of income a worker saved by buying a stock at a discount.
You can get an accurate basis (the amount originally paid for the stock) if you know the compensation income. Then you can put the correct numbers on your tax return.
Three Ways to Measure
You can measure compensation income in three ways. The one you use will depend on whether there's a qualifying disposition or a non-qualifying disposition.
The first method takes the fair market value (FMV) of the stock on the date the option was granted (dg). It subtracts the price paid to exercise the option (P): FMVdg minus P.
The second takes the fair market value of the stock on the date the stock was sold (ds). It subtracts the price paid to exercise the option: FMVds minus P.
The third method takes the fair market value of the stock on the date the option was exercised (de). It subtracts the price paid to exercise the option: FMVde minus P.
Compensation income is the lower of method one or two for qualifying dispositions. It's the third method for non-qualifying dispositions.
Most of this data is found on Form 3922. Employers prepare this form and issue it to their workers whenever stock is transferred under an ESPP. The fair market value on the date the client sold the stock is not on the form.
Form 3922 is needed for the second formula. The fair market value of the stock on the date sold will show up on the Form 1099-B from the brokerage.
Working With Form 3922
Form 3922 is the "Transfer of Stock Acquired Through an Employee Stock Purchase Plan Under Section 423(c)." Companies issue this form to their workers showing information about the transfer of stock under an ESPP. It contains most of the data you'll need to run any calculations for ESPP shares.
The form includes the information needed to figure a person's compensation income, basis, and qualifying holding period in the ESPP shares. But Form 3922 does not include the selling price for the shares.
Basic ESPP Math using Form 3922
Use the latter of two dates to determine the date the ESPP shares turn from non-qualifying to qualifying:
- The date legal title transferred (Box 7) plus one year, or
- The date the option was granted (Box 1) plus two years
Compensation income on a qualifying disposition is the lesser result of two methods:
- FMV per share on the grant date (Box 3) less the exercise price paid per share (Box 5) times the number of shares transferred (Box 6) or
- FMV per share at disposition less the exercise price paid per share (Box 5) times the number of Shares Transferred (Box 6)
Compensation income on a non-qualifying disposition is calculated by this method:
- FMV per share on the exercise date (Box 4) less the exercise price paid per share (Box 5) times the number of Shares Transferred ( Box 6 )
Basis can be figured in two ways:
- Exercise price paid per share (Box 5) times the number of shares transferred (Box 6) plus compensation income plus commissions and fees to buy and sell the stock, or
- Option price plus compensation income plus commissions and fees
The Tax Impact
The income is taxed using ordinary tax rates using these formulas to determine compensation income. The rates range from 10% to 37% as of 2021. This is used for both qualifying and non-qualifying dispositions.
Capital gains or losses are figured in the same way for qualifying and non-qualifying dispositions. The gain is the difference between the proceeds you received from selling the stock and your basis in the stock:
- Capital gain (or loss) equals gross proceeds less your basis
There's no compensation income if the worker paid full price for the stock because there was no discount. Gain or loss is calculated as above. But the method simplifies if there's no compensation income:
- Capital gain (or loss) equals gross proceeds less option price less 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 income, so it's added to your wages and reported on Form W-2. But it's not subject to FICA taxes.
Compensation income from an ESPP is added to your earnings. But it's not added to your paycheck. The value is in your brokerage account or in the stock itself. The broker reports the transaction and the income on Form 1099-B.
Reporting ESPPs On Your Tax Return
First calculate compensation income from scratch, using all your brokerage statements and tax documents. Compare your result to the amount on your Form W-2.
Now calculate your basis, also from scratch. Figure the original basis, then the adjusted basis with the compensation income added in, as well as brokerage commissions.
Compare these figures to those that appear on the Form 1099-B and any supporting statements. Enter the difference in the adjustment column of Form 8949 if Form 1099-B shows only the "original" basis. No adjustment is needed if the 1099-B shows the true and correct basis as adjusted for the compensation income.