I recently discovered that there are special tax laws regarding gains made from selling stock acquired through an Employee Stock Purchase Plan (ESPP). Below is the result of my research to understand these laws.
Normal Stock Transactions
In a normal stock transaction, you report a capital gain and pay tax on any money you make on the sale of the stock beyond what it cost you to buy the stock:
Capital Gain = Total Sale - Total Cost
If you were selling a batch of stock that was all purchased at the same time at the same price, this calculation can be very simple. However, it can become complex when you sell a batch of shares that have multiple purchase dates and prices. Most brokerages will keep track of this information and just tell you what your gain is for that sale thus facilitating tax reporting.
Aside from calculating your gain, the other thing you have to look at is how long the shares were held. If there were held for less than a year (short term), it will be taxed differently than shares held longer than a year (long term). Again, your brokerage's year end report should break this down for you.
Tax Reporting For ESPPs
An Employee Stock Purchase Plan is a program offered by your employer that allows you to purchase shares of the company's stock often at a discounted price. The program will usually have an offer period during which you will have a payroll deduction that goes into a holding account. When the offer period is over, the money in that account is converted to stock.
When you sell the stock, you will have a gain or a loss based on what you paid for the stock and what you sold it for. On the surface, this appears to be just another regular stock transaction, but as I found out, there is a significant difference. The difference is that the amount of discount you received when purchasing the stock will have to be reported as ordinary income (not capital gains).
Consider a plan where you get a 10% discount on your stock. At the end of the offer period, the market price for a share is $10. With your 10% discount, you pay $9 per share. If you bought 100 shares, you just got a discount of $100 ( (10 - 9) * 100 ). That $100 should be reported as ordinary income, and instead of using $9 per share as your cost basis for your shares, you use $10 per share.
The above example is overly simplified to demonstrate the principle. However, the actual law is quite a bit more confusing. Different rules apply if you sell your shares after holding them for at least two years (
Qualified Distribution) than if you hold for less than two years (
Disqualified Distribution) so we will examine each separately.
Disqualified Distribution
In a disqualified distribution, you held your shares less than two years. If you held less than one year, they are also a short-term gain.
To calculate the total amount of discount that must be reported as ordinary income, you must take the
market price on the day the shares were purchased,
minus the actual price paid (the discounted price),
times the number of
shares:
Discount = (Market Price Per Share - Discounted Price Per Share) * Number of Shares
The discount amount should be included in your ordinary income (Wages, Tips, etc). For a disqualified disposition, your employer should INCLUDE this in the box 1 (wages) of your W-2. Mine did, and in box 14 (other), they listed ESPP DISQ DISP and the amount of the discount that was ALREADY included in my box 1.
If you used the actual discounted price as the cost basis, you would be double taxed on the discount amount as it will be included in both your ordinary income AND your capital gains income. When you do your capital gains worksheet (Schedule D), you should use the
Market Price as the cost basis of these shares thus avoiding the double taxation.
Qualified Distribution
A qualified distribution is a sale of shares held more than two years. This automatically means it is also a long term capital gain since it has been held for more than one year. The rules for a qualified distribution are slightly different than for a disqualified one.
First, you still have to calculate the amount of discount that your received on your shares. However, this is done by taking the
LESSER of two calculations.
First, calculate the actual gain based off of the discounted price:
Actual Gain = (Sell Price Per Share - Discounted Purchase Price Per Share) * Number Of Shares
Second, calculate the discount based off the offering price (this is the market price per share on the beginning of the offer date):
Discount = Market Price on Offer Date * Discount Rate% * Number of Shares
Take the smaller of these two numbers and this is the amount that you must report as ordinary income. However, unlike a disqualified disposition, the amount is most likely NOT already reported by your employer in box 1 of your W-2. That means that you must manually add this to your income (wages, salaries, tips, etc).
Again, you need to adjust the cost basis of your shares upward by the amount you reported as ordinary income so that you are not double-taxed on that amount.
Summary
Overall, the wording of the laws is fairly complex. It took me many hours of research to get to a point where I now have a pretty good understanding of what to do for these types of transactions. I have put together a spreadsheet to help me do my ESPP reporting. You can download it here and use it to help you in your own reporting.
I dedicate these two ESPP Tax Calculations files to the public domain so feel free to use them any way you wish.
ESPP Tax Calculations.ods - Open Document Spreadsheet format for
OpenOffice.org
ESPP Tax Calculations.xls - MS Excel spreadsheet
Links
TurboTax Page Regarding ESPP
Fairmark Page Regarding ESPP Qualified Distributions
IRS Publication 525 - PDF File 1.1MB
Disclaimer
I am not a tax professional, so this information should not be taken as tax advice. I'm simply stating how I have handled the situation.
