Employee Stock Purchase Plan (ESPP) Taxes: A Guide

If your company offers you a qualified employee stock purchase plan (ESPP), you have the opportunity to purchase company stock at a discount, which is an added employee benefit. What can be challenging is trying to navigate how ESPPs are taxed. In this article, we'll help you understand the taxes on your ESPP and what documents you or your tax advisor will need to file in the United States.

Note: This guide only addresses tax treatment for qualified ESPPs under Section 423 of the U.S. tax code. If you're participating in a nonqualified ESPP or you are a non-U.S. employee receiving ESPP stock, the tax treatment is generally different.

In most ESPP plans, you make contributions to a stock purchase fund for a certain period of time through payroll deductions. Your employer then uses the money in the fund to purchase company stock for you at a discount of up to 15%. Generally, you don't pay taxes until you sell the shares.¹

The ESPP tax rules are complex and you should consult your tax advisor regarding your particular situation before reporting. But, in general, the tax treatment for ESPPs depends on how long you hold the shares before selling them. Depending on this time period, the sale (referred to as the "disposition") will be classified as either qualified or disqualified.

Qualified dispositions typically help lower the amount subject to ordinary income tax, potentially giving you a more favorable tax treatment than disqualified dispositions. To be qualified, you must meet both of the following holding period requirements before selling:

• The sale must be more than one year from the purchase date (the date when your employer purchased the shares for you); and
• The sale must be more than two years from the grant date (the first day your employer allows you to start ESPP contributions from your paycheck). It's also known as the offering date.

Disqualified dispositions don't qualify for preferential tax treatment since you sold the stock before meeting both holding period requirements. With a disqualified disposition, the amount of ordinary income reported on your W-2 could be higher.

If you sell stock from your ESPP plan, you'll be subject to taxation on:

1. The "discount" is based on whether your disposition was qualified or disqualified.
2. Any increase in stock value over the purchase price plus the "discount" amount.

With a qualified disposition, you're taxed at the ordinary income rates for the discount based on the lesser of:

1. The discount percentage multiplied by the grant date fair market value (FMV), or
2. The actual gain based on the price you sold the stock for and the purchase price.

Any additional profit from an increase in stock value (purchase price plus the discount amount) will be taxed at a lower rate—a long-term capital gains rate. If your shares decrease in value and you sell them at or below the purchase price, you may have a capital loss.

Example 1: Sarah sold her ESPP shares at $81 in a qualifying disposition. Her purchase price was $45 based on a 15% discount on the grant date FMV of $53. Since this was a qualified disposition, she'll only have to pay ordinary income on the discount and the rest of the gain will be taxed at the lower long-term capital gains tax rates. In this case, her discount that is taxed as ordinary income will be $8 per share (15% of $53 grant date FMV), which is less than the actual gain of $36 per share ($81 sale price minus $45 purchase price). Her long-term capital gain is $28 ($81 sale price minus $53, which is the adjusted cost basis when you add the $8 discount to the $45 purchase price).

Example 2: Mary sold her ESPP shares at $58 in a qualifying disposition. Her purchase price was $51 based on a 15% discount on the grant date FMV of $60. Her discount that is taxed as ordinary income will be $7 per share ($58 sale price minus $51 purchase price) since that is less than the $9 per share (15% of $60 grant date FMV). Her long-term capital gain is $0 ($58 sale price minus $58, which is the adjusted cost basis when you add the $7 discount to the $51 purchase price).

With disqualified dispositions, you're taxed at the ordinary income rates on the discount; however, the discount is not based on the grant date share price, it's based on the purchase date share price. This means the discount taxed as ordinary income is based on the FMV of the share on the purchase date minus the actual purchase price. Any additional profit from the spread is considered capital gain (short-term or long-term rates apply depending on the amount of time you've held the shares).

Example 1: Bill sold his ESPP shares at $80 in a disqualifying disposition. The FMV of the shares on the purchase date was $60. His actual purchase price was $45, based on a 15% discount on the grant date FMV of $53. Since this is a disqualified disposition John's discount is $15 ($60 minus $45), not $8 ($53 minus $45). John held his stock for less than a year and his short-term capital gain is $20 ($80 minus $60 which is the adjusted cost basis when you add the $15 discount to the $45 purchase price).

Example 2: John sold his ESPP shares at $49 in a disqualifying disposition. The purchase date FMV was $50, his purchase price was $34 based on a 15% discount on the grant date FMV of $40. John's discount is $16 ($50 minus $34). John held his stock for less than a year and his short-term capital loss is $1 ($49 minus $50, which is the adjusted cost basis when you add the $16 discount to the $34 purchase price). Note: in this case John still must realize the entire discount as ordinary income and can potentially offset other capital gains with the $1 short term capital loss. If he has no capital gains to offset, then he can potentially offset up to 3,000 of ordinary income.

Here's an overview of the documents you may need when filing in the U.S., and how you, or your tax advisor, will use them.

After you sell ESPP shares and prepare to file your taxes, you'll need to report ordinary income and capital gains/losses. Your employer will typically include ESPP income in box 1 of your W-2. However, your employer is not required to report ESPP income on your W-2. If it's not included, you're responsible for reporting the income on Form 1040 as ordinary income.

Note: Your employer will also send an informational Form 3922 for the year ESPP stocks were purchased.

When you sell ESPP shares, you need to report the capital gains or losses from the sale. Capital gains and losses are generally defined as the difference between the price you bought the stock for—or the cost basis—and what you sold it for (the sale proceeds).

Refer to Schwab's cost basis sheet to help you determine the cost basis on your stock plan transactions so you can file your taxes accurately. Generally, the cost basis can be found in Box 1e of your Form 1099-B, but this amount may need to be adjusted for the discount assessed as taxable compensation income in your W-2.

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