Disclaimer:
While the following article addresses many of
the common issues relating to employee stock purchase plans, there are a number
of considerations that can be specific to your employer’s plan or, more
importantly, your personal tax or financial situation.
We would suggest that you contact
Beacon Financial Strategies or your tax advisor
prior to making any decisions relating to your ESPP investment strategy.
Employee Stock Purchase Plans (ESPP) can provide both
executives and rank-in-file employees with an effective method of investing in
their company’s stock.
However,
understanding the potential tax implications of this transaction is a critical
component of implementing a successful ESPP investment strategy.
Employee Stock
Purchase Plan (ESPP)
With employee stock purchase plans, employees are given the
opportunity to buy company stock (usually at a discounted price).
Generally, an employee chooses the amount
they want to contribute each pay period and the employer deducts that amount,
after tax, from the employee’s paycheck.
Money withheld from the employee’s paycheck will accumulate until the
end of the offering period when it is used to purchase shares of the company’s
common stock.
Some companies offer a "lookback” period, so that the price
the employee pays is based on the price at the beginning or the end of the
offering period, whichever is lower.
With this type of plan, the employee could receive an extra benefit, if
the stock price appreciates during the offering period, as they would buy in to
the stock at lower levels.
Usually, when the shares are purchased, the employee has the
ability to sell the shares at any time.
However, income tax liabilities are deferred until the shares are
sold.
The actual income tax payable on
this transaction are dependent on how long the shares have been held.
Disqualifying Dispositions
The taxation on the sale of the stock depends on whether or
not the transaction is a disqualifying disposition.
A disqualifying disposition is when both of
the following are true:
-
The shares have been held less than
one year
since the purchase date AND
- It has been less than
two years since the
beginning of the offering period.
If the sale of the stock is considered a disqualifying
disposition, the difference between the purchase price and the market price on
the date of the purchase (the discount) would be added to an employee’s
compensation.
The disqualifying disposition
is reported on the employee’s W-2 and would be taxed at ordinary income tax
rates.
The remaining gain or loss on the sale is taxed based on the
holding period of the stock.
Short Term Holding
Periods
When a stock is sold less than one year after the purchase
date, it is considered a short term capital gain (or loss).
The tax rate for short term capital gains (or
losses) is considered to be the employee’s ordinary tax rate.
Example: Joe purchases his company stock shares at $7.50
when the price of the stock is $10.
He
holds the shares for six months and sells them at $15 per share.
Compensation of $2.50/share ($10-$7.50) is
added to his gross pay and reported in his W-2.
In addition, he would also report a short term capital gain of $5/share
($15-$10) on his tax return.
The $5/share
gain would also be subject to Joe’s ordinary income tax rate.
Long Term Holding
Periods
A long term holding period is considered to be at least one
year after the purchase date.
Even
though an employee holds the stock for one year before the sale, the
transaction can still be a disqualifying disposition because as shares may
still be held for less than two years after the beginning of the offering
period.
With long term disqualifying dispositions, the purchase
discount is taxed as ordinary income.
However, the remaining
gain (or
loss) from the sale would be taxed at long term capital gains tax rates which
are currently lower than ordinary income tax rates.
Example: Jim purchases shares at $7.50 when the price of
the stock is $10. He holds the shares for just over a year and sells them at
$15 per share.
Compensation of
$2.50/share ($10-$7.50) is added to his pay.
In addition, he would also report a long term capital gain of $5/share
($15-$10) on his tax return.
The maximum
rate (under current law) for capital gains is 15%.
A Scenario to
Consider
There is one particular situation in which the holding
period is very important.
Consider the
following:
If an employee has a sizable benefit at the time of
purchase, but the stock price declines sharply afterward, the employee can
actually pay tax on "phantom income” if they make a disqualifying disposition.
Example:
Sue
purchases $10,000 of stock during an offering period and the stock price rises
dramatically. The stock is valued at $25,000 at the end of the offering
period.
She holds onto the stock and the
price falls leaving her with shares worth just $8,000.
In this situation, a disqualifying sale will
require her to report $15,000 of compensation income. She will also have a
$17,000 capital loss on the sale.
Unfortunately, because of the capital loss limitation she may only be
allowed to deduct $3,000/year.
By contrast, if Sue held the shares
long enough to avoid a disqualifying disposition, she would subsequently report
no compensation income in this situation.
As such, she would only have to report a capital loss of $2,000.
Qualifying Dispositions
A qualifying disposition is when both of the following are
met:
-
The ESPP shares have been held more than
one
year from the purchase date
AND
-
It has been more than
two years since the
beginning of the offering period.
Because with all qualifying dispositions, the shares have to
be held at least one year, the transaction automatically qualifies as a long
term capital gain.
In that case, the
taxpayer would report a capital gain (or loss) on the difference between the
sales price and the purchase price.
Because capital gains tax rates are lower than ordinary income tax rates
(assuming a stable or rising stock price), a holding period of more than two
years would presumably provide most taxpayers with the most favorable tax
treatment.
Example: Larry purchases shares at $9 when the price of
the stock is $12. He holds the shares for three years and sells them at $15 per
share.
Because this transaction is
considered a qualifying disposition, there is no compensation reported on the
sale of the stock.
Larry would report a
long term capital gain of $6 per share ($15 - $9).
The maximum rate (under current law) for
capital gains is 15%.
About Beacon Financial Strategies
Beacon Financial Strategies
is an
independent financial planning, tax and investment advisory
firm located in Raleigh, NC. Beacon works with clients on a
consultative and objective basis to help them achieve their personal financial
goals. Beacon professionals specialize in the following areas of financial
planning: retirement feasibility planning, estate planning and coordination,
tax minimization strategies, and wealth management services.
Beacon Financial
Strategies
provides both one-time and ongoing financial
planning, tax and investment advice to clients and operates in a fee-only,
fiduciary capacity.