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Home » ESPP Tax Rules: Benefits, Calculations, and Best Practices

ESPP Tax Rules: Benefits, Calculations, and Best Practices

An employee stock purchase plan (ESPP) is a benefit offered by some public companies that allows you to buy company stock at a discount on the market price. You contribute money from your paycheck for a set period to build up a savings bucket and purchase stock at the end of it. You can sell the stock when you want to, using the cash toward your personal goals.

Participating in an ESPP offers advantages, but there are also tax considerations to be aware of. Here’s a guide to ESPP tax rules that you can use to make an informed decision about contributing to your plan. Consult with a tax professional to get the best advice for your individual tax situation.

ESPP Terms to Know

Before getting into the weeds on taxes, here are some ESPP terms you need to understand: 

Offering period: The period of time for which you contribute after-tax money from your paycheck. At the end of the offering period, which can be anywhere from 3 months to 24 months, depending on your company plan, your contributions are used to purchase stock during a period of time known as the purchase period.

Lookback provision: A lookback provision sets the stock price for calculating your discount to the price at the beginning of the offering period or at the end of the purchase period, whichever is lower. If the stock price goes up during your offering period, this can help increase your benefit. Not all companies offer this helpful provision, so check your plan details.

Qualified ESPP: A qualified ESPP plan adheres to guidelines set out by the IRS, including some potentially favorable tax treatments on your stock sales. This article focuses on qualified plans.

Nonqualified ESPP: A nonqualified plan does not follow IRS guidelines, which makes it more flexible. But it also does not receive the same tax treatments that qualified plans do.

Maximum contribution: The IRS sets limits on the value of company stock employees can own via an ESPP. The limit is $25,000 per calendar year.

The Benefits of an ESPP

Advantages for Employees

An ESPP allows you to buy company stock at a discount that people outside the company do not receive. If you sell your shares immediately at the end of the offering period, at minimum, you benefit from the discount, regardless of any stock price fluctuations. If your stock price has gone up, you stand to gain even more. 

Under a qualified plan, you will pay ordinary income taxes on the discounted amount and capital gains tax rates on any gains above that amount. 

Advantages for Employers

Companies offer ESPPs to give their employees a sense of ownership, and studies show it helps employee performance and retention. 

An ESPP may also be a more cost-effective benefit for the company than other types of equity compensation, such as stock options and restricted stock units. Companies may also be able to take a corporate tax deduction on the recognized income, provided they report it on employees’ W-2s.

The Two Tax Treatments of ESPPs

Once you receive your shares and are ready to sell, there are two possible tax treatments:

Qualifying Disposition

A qualifying disposition occurs when you sell shares after holding onto them for both one year after the purchase date as well as two years after the grant date. Some companies require employees to hold on to their shares for a specific time, known as a holding period.

How it’s taxed

  • The discount is taxed as ordinary income, according to the income tax bracket you fall into. You may also have to pay state and local taxes.
  • Any profit or gain above that amount is taxed at the long-term capital gains rate – this would occur if the stock price goes up after purchasing it.

Disqualifying Disposition

If you do not meet the criteria of a qualifying disposition, the sale is considered a disqualifying disposition. You could sell your shares immediately at the end of the offering period or at any point you choose.

How it’s taxed: 

  • The discount is taxed at the ordinary income rate and you may have to also pay state and local taxes.
  • You pay short-term or long-term capital gains rates on any profit, depending on when you sell. 

How to Calculate ESPP Taxes

Let’s look at an example to understand how you can be taxed under qualifying and disqualifying dispositions. 

Let’s say you work for Company X, which offers an ESPP at a 15% discount with a lookback provision. You decide to contribute, say 10% of every paycheck during a six-month offering period to build up a total of $8,500. 

Scenario 1: Qualifying Disposition

The market price at the start of the offering period is $100. It goes up to $120 at the end of the offering period. With a lookback provision, you receive a discount on the lower of the two prices. This means you can buy shares at a 15% discount on $100 = $85/share.

At the end of the offering period, you receive $8,500/85 = 100 shares.

  1. Ordinary Income
    • Ordinary income on a qualifying disposition = discount value per share ($15) X number of shares (100) = $1,500
    • This amount is taxed as ordinary income on your return.
  1. Capital gain/loss
    • Now suppose the day you sell the stock, after meeting the conditions of a qualifying disposition, the price is $140/share. You sell your shares for $14,000. You will pay long-term capital gains on this sale. 
    • Capital gain (or loss) = Proceeds from the sale – Cost basis 
    • The cost basis is the sum of the price you paid for the shares (100 x 85) and the ordinary income amount ($1,500), which equals $10,000.
    • Long-term capital gains/loss = Sale proceeds ($14,000) – Cost basis ($10,000) = $4,000. 

Scenario 2: Disqualifying Disposition, Stock Price Goes Up During Offering Period

The market price at the start of the offering period is $100. It goes up to $120 at the end of the offering period. You buy shares at a 15% discount on $100 = $85/share. Again, you purchase 100 shares for a total of $8,500.

  1. Ordinary income 
    • In a disqualifying disposition, the market price at the end of the offering period comes into play. This changes the ordinary income calculation slightly, as follows: 
    • Discount/share = Market value on purchase date ($120) – discounted share price ($85) = $35
    • Ordinary income on a disqualifying disposition = discount value per share ($35) X number of shares (100) = $3,500
  1. Capital gain/loss
    • Suppose you sell the stock when the price is $140/share, for a total of $14,000. 
    • Capital gain (or loss) = Proceeds from the sale – Cost basis 
    • Cost basis = sum of price paid for shares ($8,500) + ordinary income ($3,500) = $12,000
    • Capital gain = Sale price ($14,000) – Cost basis ($12,000) = $2,000.
    • Since this is a disqualifying disposition, you will be taxed at the short-term or long-term capital gains rate, depending on whether you sold the stock after one year or earlier. 

Scenario 3: Disqualifying Disposition, Stock Price Goes Down During Offering Period

In this disqualifying disposition scenario, suppose the market price at the start of the offering period is $120 and then it drops to $100 at the end. You still buy 100 stocks for $85/share. For tax calculations, the market price at the end of the offering period matters. 

  1. Ordinary income
    • Discount/share = Market value on purchase date ($100) – discounted share price ($85) = $15
    • Ordinary income = the discount per share (15) X number of shares (100) = $1,500.
  1. Capital gain/loss
    • Suppose you sell the stock at $140/share. The capital gains are calculated the same way:
    • Capital gain = Sale proceeds ($14,000) – Cost basis ($8,500 + $1,500) = $4,000.

Here’s a summary of all three scenarios: 

ScenarioOrdinary incomeCapital gain/loss
Qualifying disposition $1,500$4,000
Disqualifying disposition, stock price goes up$3,500$2,000
Disqualifying disposition,stock price goes down$1,500$4,000

ESPP Best Practices

As you can see, ESPP taxes are complicated, and your plan rules may determine when you’re allowed to sell shares. Here are some things to keep in mind when it comes to ESPP taxes: 

  • Selling stock immediately locks in your gains, and you can use the cash to meet your goals or diversify your investment portfolio. 
  • A common misconception is that you have to hold onto ESPP stock. If your company doesn’t have a holding period requirement, which is most companies, consider selling immediately to make a disqualifying disposition. You will have to pay a higher short-term capital gains rate, but your shares are not subject to market volatility. Even a small drop in stock price may offset any tax gains you receive from holding on to the stock.
  • If you’re in a high tax bracket, it’s important to remember you will pay the same rate on the ordinary income portion from ESPP sales. Factor that into when you want to sell stock.

Frequently Asked Questions about ESPP Tax Rules

Do ESPP benefits count as taxable income?

Yes, the discount you receive on your stock price in an ESPP is considered ordinary taxable income. Either you or your employer have to report it on your W-2 as income. Any profit you make from selling shares is taxed at the short-term or long-term capital gains rate, depending on when you sell.

How Do I Avoid Overpaying Taxes on Employee Stock Purchase Plans?

Avoid overpaying taxes on your ESPP by accurately calculating your cost basis amount for capital gains using a 1099-B and Supplemental tax forms. You receive these forms when you make ESPP sales. Always consult with a tax professional to get the best advice for your situation.