Employee Stock Purchase Plans

Many large companies offer Employee Stock Purchase Plans (ESPP) that let you buy your employer's stock at a discount. These plans are offered as an employment incentive, giving you an opportunity to share in the growth potential of your company's stock (and by implication, work hard to keep the stock price moving ahead).

Usually, you make contributions to a stock purchase fund for a certain period of time through payroll deductions. At designated points in the year, your employer then uses the accumulated money in the fund to purchase stock for you.

In many plans, the price that you pay for the stock is the stock price at the time you started contributing to the fund, or the stock price at the time your employer purchases the shares on your behalf, whichever is lower, with a discount of up to 15 percent. Either way, you get to buy the stock at a price that's lower than the market price. Your discounted price is known as the offer or grant price.

The company keeps the stock in your name until you decide to sell it. At that point you have to begin thinking about taxes.

When the company buys the shares for you, you do not owe any taxes. You are exercising your rights under the ESPP. You have bought some stock. So far so good.

When you sell the stock, the discount that you received when you bought the stock is generally considered additional compensation to you, so you have to pay taxes on it as regular income.

If you hold the stock for less than a year before you sell it, any gains will be considered compensation and taxed as such. If you hold the shares for more than one year, any profit will be taxed at the usually lower capital gains rate.

That depends on whether your stock sale is a qualifying disposition or a disqualifying disposition.

Both terms are defined below.

Disqualifying Disposition:

You sold the stock within two years after the offering date or one year or less from the exercise (purchase date). In this case, your employer will report the bargain element as compensation on your Form W-2, so you will have to pay taxes on that amount as ordinary income. The bargain element is the difference between the exercise price and the market price on the exercise date. Any additional profit is considered capital gain (short-term or long-term depending on how long you held the shares) and should be reported on Schedule D.

Qualifying Disposition:

You sold the stock at least two years after the offering (grant date) and at least one year after the exercise (purchase date). If so, a portion of the profit (the “bargain element”) is considered compensation income (taxed at regular rates) on your Form 1040. Any additional profit is considered long-term capital gain (which is be taxed at lower rates than compensation income) and should be reported on Schedule D, Capital Gains and Losses. 

In this situation, you sell your ESPP shares less than one year after purchasing them.

Example:

1. Subtract the actual price paid from the market price at the exercise date
2. Multiply the result by the number of shares: ($25 - $21.25) x 100 = $375

In this situation, you sell your ESPP shares more than one year after purchasing them, but less than two years after the offering date.

Example:

You must show the sale of the stock on your 2014 Schedule D. It's considered long-term because more than one year passed from the date acquired (January 2, 2010) to the date of sale (January 20, 2014). That is good, because long-term capital gains are taxed at a rate that is lower than your regular tax rate.

In this example, as in the previous one, the sales price you report on Schedule D is $4,990 and the cost basis is $2,500. The long-term gain is the difference of $2,490. ($4,990 - $2,500).

In this situation, you sell your ESPP shares more than one year after purchasing them, and more than two years after the offering date and the market price actually increased from the offering date to the exercise date.

Example:

Again, your employer might not report anything on your 2014 Form W-2 as compensation. But you will still need to report some ordinary income on line 7 of your 2014 Form 1040, as "compensation." You report the lesser of:

• The gross sales price of $5,000 minus the $1,275 actual discounted price paid for the shares ($12.75 x 100) minus the $10 sales commission= $3,715, or
• The per-share company discount times the number of shares. ($2.25 x 100 shares = $225).

So you must report $225 on line 7 on the Form 1040 as "ESPP Ordinary Income."

You must also report the sale of your stock on Schedule D, Part II as a long-term sale. It's long term because there is over one year between the date acquired (6/30/10) and the date of sale (1/20/2014).

The sales price reported on Schedule D is $4,990 ($5,000 gross proceeds - $10 commission). The cost basis is the actual price paid per share times the number of shares ($12.75 x 100 = $1,275), plus the amount that you're reporting as compensation income on line 7 of your Form 1040 ($225). Therefore, your total cost basis is $1,500, and the long-term capital gain reported on Schedule D is $3,490 ($4,990 - $1,500).

Your employer is not required to withhold Social Security (FICA) taxes when you exercise the option to purchase the stock. Also, your employer is not required to withhold income tax when you dispose of the stock. But you still owe some income tax on any gain resulting from the sale of the stock.