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ESPP Tax Consequences

Employee Stock Purchase Plans (ESPP) are one of many stock incentive programs employers use to compensate employees. They typically give the employee a discount when purchasing the company's stock but often vary as to the details such as amount of the discount, the market price used to calculate the discount and subsequent purchase price, and purchase dates. Frequently payment is withheld from the employee's paycheck over a period such as six months, and shares are purchased at a discount at the end of the six-month period. If the employee sells the purchased shares immediately, the gain is the amount of the discount offered at purchase. For example, if a 15% discount off of the market price at the time of purchase is used, the employee receives a 15% return (less taxes) on their investment if the shares are immediately sold. This 15% gain is called the bargain element.The amount of tax depends on the length of time the stock is held as well as whether the shares are sold as a qualifying disposition. To be a qualifying disposition, the shares must be both of the following criteria:

• Shares sold more than one year after the purchase of the shares.
• Shares sold more than two years after the offering date.

This results in four primary tax consequences:

1. Shares sold less than one year after the purchase date (Short-term Disqualifying Disposition): The bargain element, or discount received, is taxed as ordinary income (i.e. your normal tax bracket). Any gain above the bargain element resulting from an increase in the stock price is taxed as a short-term capital gain at the same tax rate as ordinary income.
2. Shares sold more than one year after the purchase date but less than two years from the offering date (Long-term Disqualifying Disposition): The bargain element is taxed as ordinary income and any gain from the increase in stock price is taxed as long-term capital gain, which is typically a lower rate, currently at 5% or 15% depending on your tax bracket.
3. Shares sold more than 1 year from the purchase date and after two years from the offering date, and the stock price decreased from the offering date to the purchase date (Long-term Qualifying Disposition): The portion of the gain taxed as ordinary income is the lesser of a) the discount multiplied by the market price at the offering date or b) the difference between the selling market price and the discounted purchase price. The remaining gain is taxed as a long-term capital gain. This allows a portion of the bargain element to be taxed as long-term capital gain.
4. Same as (3) above but the stock price increases from the offering date to the purchase date: The portion of the gain taxed as ordinary income is the market price at the offering date multiplied by the discount. The remaining is taxed as long-term capital gain. This also results in a portion of the bargain element to be taxed as long-term capital gain.

For some examples of the above situations, refer to this TurboTax article.

As with any stock purchase, the risk lies in not knowing whether the price will increase or decrease over the period you intend to hold it. Many are of the opinion that a quick sale after the ESPP shares are purchased will at least guarantee a return in the amount of the discount (e.g. 15%) less your applicable ordinary income tax bracket rate. If you are in the 25% tax bracket, this is a return of 11.25% (15% x (1 - 25%)). Not a bad return.