The ESPP Bible – Part 2

ESPP taxation qualifying vs. disqualifying

In part 1 of the ESPP Bible we learned why ESPPs are such stellar investments, and why you should fall over yourself in your hurry to sign up for the plan should you be lucky enough to have access to one. Today, we will examine the dark underbelly of ESPPs – how the stocks purchased on your behalf by the ESPP are taxed. Fair warning: things are going to get very complicated.

 

Once again, let’s begin with a TL;DR 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 a 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

I urge you to refer back to part 1 if you need to review the terms, because we are going to use them liberally as we wander down the thorny path of ESPP taxation.

 

Taxes Owed When Stocks Are Purchased

On the purchase date your company will purchase shares on your behalf at the discounted rate using the accumulated funds from your after-tax paycheck deductions. ESPP purchase is not a taxable event. You owe no taxes until the time that you decide to sell the stock.

 

Taxes Owed When Stocks are Sold

When you sell your stock, you will trigger a taxable event. The tax you owe will have an income tax component and may have a short or long term capital gains (LTCGs) component. To determine the portion of your sale proceeds that will be treated as income and the portion that will be treated as capital gains, you first need to determine the disposition of the sale.

ESPP taxation qualifying vs. disqualifying

Irrespective of the disposition of the sale, you never owe FICA taxes on an ESPP sale. In subsequent sections I am going to focus on federal taxes owed. You may also owe your state taxes.

 

A Sale with a Disqualifying Disposition

If you choose to keep your life as simple as possible, and sell your ESPP as soon as it is purchased, then from a tax perspective this is the only section of this post that you need to read. You can skip right over all the talk about qualifying dispositions.

ESPP taxation disqualifying disposition

Let’s look at a few examples of ESPP sales with disqualifying dispositions.

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 a marginal income tax rate of 25% and a LTCG tax rate of 15%. We are filing as single, and therefore can write off up to $1,500 in capital loss against income.

ExampleDate of sale
Sale priceIncomeGains or LossTax owed
1. Stock held for less than a year from purchase.July 2016$24($20 - $15.30) * 100 = $470($24 - $20) * 100 = $400($470 * .25) + ($400 * .25) = $217.5

2. Stock held for more than a year from purchase, but less than two years from grant.
June 2017$24($20 - $15.30) * 100 = $470($24 - $20) * 100 = $400($470 * .25) + ($400 * .15) = $177.5
3. Same as ‘2’ but sale price is less than FMV on purchase date.June 2017$16($20 - $15.30) * 100 = $470($16 - $20) * 100 = -$400($470 - $400) * .25 = $17.5
(we deducted the capital loss from our income)

4. Same as ‘2’ but sale price is less than discounted purchase price.
June 2017$13($20 - $15.30) * 100 = $470($13 - $20) * 100 = -$700$0 (because the $700 capital loss offset all our income).

Examples 3 and 4 are interesting because they illustrate one way in which ESPPs can get you into trouble if you choose to hold onto them. In these examples the stock price tanked but the discount you received is still treated as income that you owe taxes on!

 

Wipe the sweat off your brow. Take a swig of something strong. And let’s dive into the wonderful world of qualifying dispositions.

 

A Sale with a Qualifying Disposition

ESPP taxation qualifying disposition

Let’s look at a few examples of ESPP sales with qualifying dispositions. We will use the same purchase price, discounts and sale prices that we used for the disqualifying disposition examples above.

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 a marginal income tax rate of 25% and a LTCG tax rate of 15%. We are filing as single, and therefore can write off up to $1,500 in capital loss against income.

ExampleDate of sale
Sale priceBargainGains or LossIncomeTax Owed
1. Stock held for more than two years from grant date.December 2017$24($18 - $15.30) * 100 = $270($24 - $15.30) * 100 = $870min($270, $870) = $270($270 * .25) + ($870 - $270) * .15 = $157.5
2. Same as 1, but sale price is lower than the grant price.December 2017$16($18 - $15.30) * 100 = $270($16 - $15.30) * 100 = $70min($270, $70) = $70$70 * .25 = $17.5

3. Same as 1, but sale price is lower than discounted price.
December 2017$13($18 - $15.30) * 100 = $270($13 - $15.30) * 100 = -$230$0No income tax. $230 in capital losses can be written off against other gains or income.

In all of these example it appears that a sale with a qualifying disposition performs as well as or better than that with a disqualifying disposition with respect to taxation. Remember what they say about appearances? Appearances are deceptive.

 

Is a Qualifying Disposition Always Superior to a Non-qualifying Disposition?

Nope. Consider the following example.

An ESPP offering a 15% discount with look-back. If the stock price was $18 on the grant date in November 2015, and then fell to $15 on the purchase date in May 2016, we would purchase the stock at $12.75/share. Let us assume that we purchased 100 such shares.

Date of sale
DispositionSale priceBargainGainIncomeTax Owed
June 2016Disqualifying$24N/A($24 - $15) * 100 = $900($15 - $12.75) * 100 = $225($225 * .25) + (900 * .15) = $191.25
December 2017Qualifying$24($18 - $12.75) * 100 = $525($24 - $12.75) * 100 = $1125min($525, $1125) = $525($525 * .25) + ($1125 - $525) * .15 = $221.25

Shocker! You pay less tax with a disqualifying disposition. Since the income for a qualifying disposition is based on the price on the grant date, in cases where the purchase price is lower than the grant price, qualifying dispositions can perform worse than their less qualified counterparts.

 

Lessons Learned and a Preview of Part 3

ESPPs are wonderful, and if you can get your hands on one, please do partake. Partake like a starving glutton at a buffet. ESPP taxation, on the other hand, can give you ulcers. My advice is to maintain your sunny disposition by selling forthwith and avoiding the whole steaming pile of disqualifying vs. qualifying dispositions.

In the next and final installment of the ESPP Bible I will cover how your employer and your broker are likely to report the various ESPP numbers, and how you need to fill your tax forms.

<

One thought on “The ESPP Bible – Part 2”

  1. This is awesome! Thank you so much for the very detailed explanation. This is the most useful explanation I’ve found. – Sentalis Zindabad.

Leave a Reply