Under a section 423 plan you pay tax once, when you sell.
Nothing reaches your return at grant or at purchase. At sale you report part of the proceeds as ordinary income and part as capital gain.
Key takeaways
You have to satisfy two holding clocks.
Two years from the grant date, one year from the purchase date. Miss either and you report more of the sale as ordinary income.
Check the cost basis on your 1099-B before you file.
Your broker reports what you paid and leaves out the income you already reported as wages. File it unchanged and you pay tax on the same money twice.
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How an ESPP is taxed
Four moments matter, and you pay tax at the last one
Your employer offers an ESPP so you can buy company stock at a discount, paying for it through payroll deductions across an offering period. Four moments matter for tax, and you pay at the last one.
A qualified plan meets section 423:
- Your employer offers it to employees generally. The statute permits four exclusions: new hires under two years, people working 20 hours a week or less, people working five months a year or less, and highly compensated employees.
- You pay no less than 85 percent of the share price. Your employer measures that price at either the start of the offering period or the purchase date, whichever is lower.
- You buy within 27 months of the grant.
Under a nonqualified plan you report the discount as ordinary income in the year you buy, your employer runs it through your W-2, and your basis is the full purchase date value.
01In order
The four phases of an ESPP, and what each one means
Four moments matter for tax. Here is what happens, and what does not, at each one.
Phase one, the grant
The offering period opens and your contribution rate is set. Nothing is taxable and nothing appears on your return.
Record the grant date. Your two year clock starts from it. Where your plan prices off the lower of the two dates, the grant date price is also what sets the ordinary income you report on a qualifying disposition, years after you bought.
Phase two, the purchase
You buy shares with the deductions you have accumulated, at a discount of up to 15 percent.
You pay no tax at purchase in a qualified plan either. You now hold something worth more than you paid, and you report nothing until you sell.
Your employer files a Form 3922 for the year of purchase and gives you a copy by January 31 following it. Keep it. You will find the grant date, the purchase date and the prices on it, and those are the figures you need at sale, sometimes years later.
You can accrue the right to buy $25,000 of stock a calendar year, measured at the grant date price. Congress set that limit in section 423(b)(8), across all your employer’s qualified plans. You measure the $25,000 against the fair market value on the day your offering period opened, not against the discounted price you pay. At a $100 grant price you reach the limit at 250 shares.
Phase three, the two holding clocks
Both clocks must run out. Whichever ends later is the date that matters.
You start the two clocks on different dates, so they end on different dates. Whichever ends later is the date you have to reach.
- Two years from the grant date. You start this clock when your offering period opens, so it ends later than the purchase date clock wherever your offering period runs longer than a year.
- One year from the purchase date. The shorter clock.
Satisfy both and the sale is a qualifying disposition. Sell before either is up and it is a disqualifying disposition, which is a description rather than a penalty. Sometimes selling early is the right call, and concentration risk in your employer’s stock is a real reason to do it.
Phase four, the sale
- A qualifying disposition. Ordinary income is the lesser of the discount measured at grant or your actual gain on the sale. Everything above that is long term capital gain.
- A disqualifying disposition. You report the purchase date fair market value minus what you paid as ordinary income, whatever the share price did afterwards. You report the rest as capital gain or loss, short or long term depending on how long you held.
Sell before you have satisfied both holding periods, after the stock has fallen, and you owe ordinary income tax on a spread larger than your whole gain. You take a capital loss on the other side. You can deduct only $3,000 of net capital loss against other income in a year, or $1,500 if you file separately from your spouse. You carry the rest forward indefinitely, and it keeps its short or long term character.
02Withholding
What your employer reports, and what it does not withhold
Your employer reports the ordinary income on your W-2 and withholds nothing against it, on either kind of disposition.
No federal income tax.Your employer withholds against your salary and against a bonus. It does not withhold against ESPP disposition income.
No Social Security or Medicare.Your employer does not count ESPP option income as wages for those taxes, or for federal unemployment tax.
So you report income on your W-2 with no tax paid against it. You cover it out of the sale proceeds or your next payment. Where the amount is large enough to leave you short at filing, you make an estimated payment for the quarter and avoid an underpayment penalty.
Check that it is there before you assume it is. Your employer reports the income only where it knows about the sale, and it learns of the sale from the plan administrator. Where the amount is missing from your W-2, you compute it from your Form 3922 and add it to your wages on your return.
03Cost basis
How to fix the cost basis on your 1099-B
Your broker reports what you paid for the shares and leaves out the income you already reported as wages.
File that figure unchanged and you pay tax on the same money twice, once as wages and again as capital gain.
You correct it on Form 8949, and what you correct depends on the disposition:
| Disposition | Basis correction |
|---|---|
| After a qualifying disposition | You raise the basis by the ordinary income you reported. |
| After a disqualifying disposition | Your basis is the purchase date fair market value, which is what you paid plus the spread your employer already reported as wages. |
You need three documents:
- The 1099-B, for the proceeds.
- The Form 3922, for the grant date, purchase date and prices.
- The W-2, for the year of sale.
Worked example
The same shares, both ways
One purchase, two sale dates, two different bills. Assume a 15 percent discount, a grant price of $20, a purchase price of $30, and 100 shares. Your plan includes a lookback, so you pay 85 percent of the lower of the two, which is $17 a share, or $1,700.
Qualifying disposition
$300
ordinary income — the lesser of the grant date discount and your actual gain
You sell at $45 more than two years after grant and more than a year after purchase. That is a qualifying disposition.
The grant date discount is $3 a share, so $300.
Capital gain: $45 minus $20, or $25 a share, so $2,500, taxed as long term.
Your basis on Form 8949: $1,700 plus $300, or $2,000.
Disqualifying disposition
$1,300
ordinary income — the purchase date price minus what you paid
You sell at $45 within a year of purchase. That is a disqualifying disposition on the same shares.
$30 less $17, or $13 a share, so $1,300.
Capital gain: $45 minus $30, or $15 a share, so $1,500, taxed as short term.
Your basis on Form 8949: $3,000, the purchase date value.
You report $2,800 of gain either way. Wait for both clocks and you shift $1,000 of it from ordinary rates to long term capital gain rates, and you take the remainder as long term gain.
[ Check your ESPP basis before you file ]
Send us the 1099-B, the Form 3922, and the W-2. We will work out whether the basis needs adjusting and how much it is worth. Call (212) 641-0673 or send the contact form.
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From the record
On holding periods, and on handling tricky situations
"Get into each one of the stocks that you're about to sell and make sure that you are using the proper capital gain strategy, because the amount of time that you held on to the stock is really going to influence how much tax you pay."
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Selling ESPP shares this year
Check your ESPP basis before you file
Send us the 1099-B, the Form 3922, and the W-2. We will work out whether the basis needs adjusting and how much it is worth. Call (212) 641-0673 or send the contact form. No charge for the conversation.
Reviewed by George Dimov, CPA, New York, NY. Serving clients in all 50 states, 15+ years advising New York businesses and individuals. President of George Dimov, CPA, a New York City firm serving clients across the five boroughs and nationwide.