The ESPP Bible – Part 3

In the first two parts of this series we have seen both the best of ESPPs (an ROI and risk profile that you would be hard pressed to beat), and the worst (the dark underbelly of ESPP taxation).

In part 3 of the ESPP Bible we are going to cover the practical aspects of filing ESPP taxes. We will cover how your employer will report ESPP income, what forms you can expect to receive from your broker and which IRS forms should be of special interest to you.

 

Before we go there though, let us once again summarize for the lazy:

  • If your company offers an ESPP without a lock-in period, you absolutely must sign up for it, and contribute the maximum allowed, if you can afford it.
  • Sell the stock the day that it vests, preferential tax treatment be damned. The risk of holding on isn’t worth it, so don’t let the tax tail wag the dog.
  • Pay close attention to the cost basis at tax time. Filing taxes for ESPP income can be more than a little tricky.

 

ESPP Terminology Reviewed

In part 1 of the ESPP Bible I defined and explained ESPP terminology, using this diagram:

ESPPs explained part 1

Do refer back to part 1 if you need to review the terms, because we are going to use them liberally as we talk about all things related to ESPP tax documentation.

 

What Documentation Can You Expect From Your Employer?

Your employer will typically report any ordinary income that results from an ESPP sale on your W-2. Note that they are not required to do so, and whether they do or not, you must report this income to the IRS. If your employer does report this income it will appear in Box 1 of your W2.

Your employer is required to file form 3922 with the IRS and to send you a copy. Here is a sample 3922 form.

 

 

ESPP tax forms
Sample form 3922

As you can see the 3922 includes all the relevant information to determine the disposition of your sale. It also includes the grant price, purchase price, FMV on purchase date and the sale price. As we have seen from the flowcharts and examples in part 2 of the Bible, this is all the information you will need to determine the taxes that you owe.

 

What Documentation Can You Expect From Your Brokerage?

Your brokerage is required to issue a form 1099-B. Up until 2013 brokerages were allowed to adjust the cost basis on the 1099-B to reflect the compensation reported by your employer on your W-2. Then the rules changed and now your broker is not allowed to adjust cost basis on the 1099-B, so unless you make an adjustment when filing your taxes, you will pay too much tax.

 

Let’s go over an example of how the 1099-B issued by your broker might be misleading.

Example 1. Consider an ESPP offering a 15% discount with look-back. If the stock price was $18 on the grant date in November 2015, and then rose to $20 on the purchase date in May 2016, we would purchase the stock at $15.30/share. Let us suppose that we purchased 100 such shares. Let us assume we sold in December 2016 at $24/share, and thus our sale has a disqualifying disposition.

Income = ($20 – $15.30) * 100 = $470
Gains = ($24 – $20) * 100 = $400

Your employer will include $470 in wages on your W2. Your adjusted basis for gains is $20. However, your 1099-B will report an unadjusted basis of $15.30.

 

If you fail to make an adjustment on IRS form 8949 you would mistakenly report a capital gain of $8.70/share (instead of $4/share), and you would end up paying taxes on the $4.70 twice. I’ll discuss how to fill form 8949 in the next section of this post. For now, just be aware that in most cases the 1099-B is not to be trusted for ESPP tax reporting.

 

Here is an example of a case in which the cost basis reported by form 1099-B will be correct for an ESPP sale. This is the case of a sale with a qualifying disposition, where your sale price is lower than your purchase price. We will use an example to illustrate the point.

Example 2. Consider an ESPP offering a 15% discount with look-back. If the stock price was $18 on the grant date in November 2015, and then rose to $20 on the purchase date in May 2016, we would purchase the stock at $15.30/share. Let us suppose that we purchased 100 such shares. We sold the shared in December 2017 at $15/share (i.e. 30 cents less than our purchase price). The sale had a qualifying disposition.

In this case your employer will not include any compensation on your W-2 (because you made no income; you incurred a loss). Your 1099-B will report the cost basis as $15.30, which is correct.

So what does this boil down to? Your 1099-B might report an incorrect cost basis. The only way you can recognize this to be so and correct it appropriately on the IRS forms is to understand exactly how much tax you owe. And for that you must refer to part 2 of the ESPP Bible.

How to Fill the Relevant IRS Forms

The IRS forms that are relevant to ESPP taxation are forms 1040, 8949, Schedule D.

Form 1040

You must include the income portion of your ESPP sale on line 7 of IRS form 1040.

ESPP tax forms
Relevant portion of form 1040

 

To recap, here is how you calculate income:

For a disqualifying disposition sale:
Income = FMV on purchase date – Discounted purchase price

For a qualifying disposition sale:
Bargain = FMV on grant date – Discounted purchase price
Gain = Sale price – FMV on purchase date
Income = minimum(Bargain, Gain)

 

Form 8949 and Schedule D

Form 8949 is used to reconcile the numbers reported on form 1099-B to the IRS with the numbers reported in your return.

ESPP tax forms

Let’s use the numbers from Example 1 above to fill out form 8949.

Enter $24 (the sale price) in column (d). Enter $15.30 in column (e) as the basis. In column (f) we enter code B from the instructions of form 8949 indicating that the basis is incorrect. In column (g) enter an adjustment of $4.70, so that you end up reporting a correct short term capital gain of $4 in column (h).

You will then use the information entered in form 8949 to populate Schedule D.

Gains must be reported on Schedule D. Short term gains (resulting from a sale with a disqualifying disposition) will be reported on Part 1 of Schedule D, and long term gains (which result from a qualifying sale and may result from a disqualifying sale) must be reported on Part II.

 

And Thus Ends the Saga of ESPPs

The ESPP Bible draws to a close. I’ll end with the Three Commandments from the ESPP Bible:

  1. Thou shalt participate in an ESPP if thou canst.
  2. Thou shalt not be a greedy little piggy and thou shalt sell as soon as thou art able.
  3. Thou shalt curse liberally whilst filling thy tax forms, but thou shalt also remember thy great gains with gratitude and remind thyself that the pain is so totally worth it.
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