Employee stock purchase plans are one of the better perks within an equity compensation plan.
They can be fairly straightforward on the surface, but there are unexpected tax complexities when you open up the hood. Spending time to understand the tax implications that can occur when you sell ESPP shares can better prepare you for surprises from Uncle Sam.
If you want to learn the basics of an ESPP or need a refresher, start here. Once you have the basics down, then you are ready to move forward to prepare for ESPP taxes.
If you are already participating in your employer’s ESPP or intend to, consider how it fits into your overall financial plan. Start by asking the following questions when implementing an ESPP as part of your financial plan:
I mentioned that ESPPs are fairly straightforward on the surface. I mean that they are easy to participate in and buy company shares at a discount. The part that you’ll want to be most aware of is the taxable event when you sell your shares.
The rules of taxation are tied to the key dates of your specific plan: The offering date, the purchase date, and the sale date. When you finally sell your shares, these dates will help determine if the sale is a qualifying disposition or disqualifying disposition.
There are two rules to be met for the sale of ESPP shares to be treated as a qualifying disposition. If you have incentive stock options, these rules may seem similar.
If both of these are met, you have a qualifying disposition which means you get preferential tax treatment. Based on ESPP rules, you may be subject to ordinary income tax and/or long-term capital gains. You’ll pay ordinary income tax on the lesser of the discount offered on the offering date price or the gain between the actual purchase price and the final sales price.
In addition, if there is any gain above the discount, you will pay long-term capital gains. This is where the preferential tax treatment comes in because long-term capital gains rates are more favorable than ordinary income rates. However, to participate in this better tax treatment, you’ll have to hang on to the stock for at least 1 year. Again, this may or may not be within your plan, so make sure you plan first, then prepare for taxes second.
Remember the important dates listed earlier? But, first, let’s look at a real-life example of a qualifying disposition.
Given this information, let’s say you are in the 24% tax bracket and 15% long-term gains bracket. In addition, you held the stock for at least 2 years after the offering date and 1 year after the date of purchase.
As you can see in this example, you would pay ordinary income tax on the discount and more favorable capital gains on the profit.
As you probably guessed, if you don’t meet either of the two rules above, you have a disqualifying disposition. In this situation, you are likely subject to both ordinary income and capital gains taxes. Now stay with me here as disqualifying dispositions can be a little tricky with taxes. First, you’ll owe ordinary income tax on the difference between the purchase price and the stock price on the date you purchase the stock. Then capital gains or loss on the difference between the stock price on the purchase date and the price the shares are finally sold at. This capital gain rate is subject to short or long-term holding periods.
Let’s look at another real-life example using the same numbers as above.
Again, you are in the 24% tax bracket and 15% long-term capital gains bracket. But this time, you held the stock for less than 2 years after the offering date and more than 1 year after the date of purchase.
And to quickly illustrate a scenario where you would owe short-term capital gains. Suppose you held the stock for less than 2 years after the offering data AND less than 1 year after the date of purchase.
The ordinary income is the same, but since you held the stock less than 1 year after the date of purchase, it would be as follows.
Just because you pay less in tax with a qualifying disposition doesn’t mean it’s always the best option. Paying less to Uncle Sam is great, but you want to view it from the lens of your own financial situation and goals. For example, it may or may not make sense to hold onto a large position in your employer stock for a longer time. The additional taxes you pay for cutting it lose earlier might buy added flexibility in your plan. On the other side, holding your employer stock long-term as part of your plan and reaping tax savings can be a plus.
The tax rules for employee stock purchase plans make planning important. It’s equally important to start by understanding the specifics of the plan offered by your employer. Plugging an ESPP strategy into your financial plan can boost your overall wealth and help you reach financial goals. Equity compensation isn’t something to take lightly. Implementing a strategy can go a long way in improving your financial situation. Review your situation with a financial professional and layout a proactive plan for equity compensation. If you need guidance on navigating your ESPP taxes or equity compensation, let’s chat!