the ins and outs of espp’s, part 2: fun with taxes!

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In the last post, we talked about the basics of ESPP’s, and I warned you that the tax situation warranted a post in and of itself. Well, here it is! With a few pictures, hopefully it will come clear.

Let’s start with the basic diagram below. At this level, the tax situation is rather simple: the difference between the price at which you bought the stock and the price at which you sold it is income, and thus is taxed.

Sounds simple, right? Well, the trick is how it is taxed. There are three options:

Compensation (ordinary income): Part of your ESPP income is taxed as compensation, i.e. at your normal income tax rate.

Short-term Capital Gains: If you held your shares for a year or less after you purchased them, the part of your ESPP income not taxed as compensation is taxed as short-term capital gains. Currently, that means they’re taxed at the same rate as compensation.

Long-term Capital Gains: If you held your shares for more than a year after you purchased them, the part of your ESPP income not taxed as compensation is taxed as long-term capital gains. Currently, that means they’re taxed at 15% or 5%, depending on your income.

OK, that doesn’t sound so bad. So that means that all we have to do is figure out how much of the income is compensation, and we’re home free, right? Well, yes…and that’s the tricky part. There are two situations we need to go into: “disqualifying dispositions” and “qualifying dispositions”.

Disqualifying Dispositions: If you did not hold your shares for more than two years after the “grant date” (beginning of the offering window; see previous postand more than one year after purchasing them, this is a “disqualifying disposition”. In a disqualifying disposition, the difference between the amount you paid for the shares and the amount they were worth when you bought them — in other words, your discount — is counted as compensation income. The rest — the difference between the amount the shares were worth when you bought them and the amount they were worth when you sold them — is capital gains; long-term if you held the shares for more than a year after purchasing them, short-term otherwise.

Sounds relatively straightforward, but what if your stock drops after you buy it? Well, the sad fact is that it the discount still counts as compensation income, even though you didn’t see a red cent of it! To be sure, the capital losses offset your income — but only up to $3,000. (The rest must be carried over to future years.)

Qualifying Dispositions: If you held your shares for more than two years after the grant date and more than one year after purchasing them, this is a “qualifying disposition”. In a qualifying disposition, your compensation income is equal to the difference between what you paid for the shares and what you sold them for or the discount (difference between what you would have paid for the shares and what they were worth) on the grant date, whichever is lower. The rest is long-term capital gains since, by definition, you held the shares for longer than one year. So an ideal situation would look like this:

That’s good — more of your income is taxed at the (lower) long-term capital gains rate. But here’s a bizarre twist: in the following situation, you would actually pay more in taxes for a qualifying disposition than for a disqualifying disposition!

Note that if this were a disqualifying disposition, your compensation income would be much smaller (look back at the second graph), and the capital gains much larger. Ouch — good things do not, apparently, always come to those who wait!

And that’s how ESPP taxes work. You’ll remember that forever, right? Well, if perchance you think something more important might displace its spot in your memory, feel free to bookmark this article and refer back to it later. (Heck, I’ll probably end up doing that myself!)

So…now what? This theoretical knowledge is all well and good, but what we should actually do with our ESPP shares? Do we participate in our company’s ESPP, or no? Do we sell some or all of the shares immediately? How long should we hold on to them? I’ll discuss all of these questions in the final post in this series.

11 thoughts on “the ins and outs of espp’s, part 2: fun with taxes!

  1. Thank you for explaining this with diagrams! I get confused by all of the “what if’s” – Can you boil this down to a “if you do it this way you will minimize your tax liability”? Thank you!

    • I would ask a different question. Rather than “what will minimize my taxes”, I would ask, “what will maximize the amount of money I get, for the least amount of risk?” The answer to that question is in the third part of this series.

  2. “but what if your stock drops after you buy it? Well, the sad fact is that it the discount still counts as compensation income, even though you didn’t see a red cent of it! To be sure, the capital losses offset your income — but only up to $3,000. (The rest must be carried over to future years.)”

    Is this valid only for disqualifying dispositions or even for qualifying dispositions ?

  3. I have shares acquired through an American company I was working for. They were purchased through the company ESPP plan. I was living and being paid in Europe at the time ( I am not a US citizen). 10 years later I have moved to the US full time and will be shortly selling these shares. Am I liable for US ordinary income tax on these shares, even though they were acquired while not a US tax payer?

  4. Hello, hope i can still get a response on this article…

    In the case of a qualified disposition where the plan has a “look back” feature, would the 4th chart still apply as drawn? In this case, the bottom dotted line (represents purchase price) would stay flat and the discount at time of purchase would be quite large. Would you still only pay income tax on the grant date discount? And would long term cap gains be paid only on difference between FMV price at purchase time and FMV at sale time? It seems this could result in a significant tax savings. It may be worth holding ESPP stock if the stock gained significantly over the offer period (grant to purchase).

    • The dotted line represents the price you paid — period. And yes, if your company has a “look back” feature, the difference between the dotted line and the solid one could indeed be quite large!

      Yes, you’re right — waiting for a qualifying disposition *could* result in significant tax savings, per your example. It’s simply a matter of rolling the dice — wait and get the tax savings, gambling that the stock market in general and your company’s stock in particular hold out, or take a sure bonus. See the next article, http://financialgeekery.com/2012/05/29/the-ins-and-outs-of-espps-part-3-so-now-what/, for my recommendation.

      • Thanks for the response. I have researched this some more and found examples. They indicate that, if the plan has look-back and the price of the stock rose over the offer period and you wait for the two years to become qualified, you will pay long-term capital gains on the amount between the sale price and the FMV at the grant date. Simple example: Let’s assume a plan with 15% discount that has look back. I’ll do this on a per-share basis. If stock is $10 at grant and $15 at purchase and you wait the two years and then sell when stock is at $20. In the qualified case, you will pay income tax on $10-$8.50 ($1.50). And you will pay long term cap gains on $20-$10 ($10).

        If we take the same example and assume disqualified status, it would be income tax on $15-$8.5 ($6.50) and cap gains on $20-$15 ($5).

        Assuming these examples are correct, your 4th chart changes quite a bit in the case of look back. Not only does the purchase price dotted line stay flat, but the dotted line at the lower end of “capital gains income” will lower to the FMV on the grant date (sold line at left side of chart). Do you agree this is correct?

  5. In the case where you have a qualifying disposition, but the stock went down since you bought it so that you end up with an overall loss, you end up with zero ordinary income and a capital loss. You don’t get to recognize negative ordinary income! The sentence still applies that you can apply up to $3000 of that capital loss against your income.

  6. Hi, thanks for useful information. I have 2 questions:
    1. Why in last two diagram we do have 2 lines besides one dash line? I am not sure what the second line (from top) represent?
    2. The purchase price (at least in our company) is the minimum price of offering date and purchasing date. So I guess the diagrams need modification, correct?

    Thanks,
    Hadi

    • 1. I agree, qualified dispositions are confusing! The line that’s exactly parallel to the dashed line is my way of trying to track your compensation income. You can ignore that line and just focused on the dashed line with arrows. The other solid line represents the actual stock price.
      2. In your case, this just means that the dashed line is flat when the stock price is higher at the purchase date than the grant date. Even better!

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