What You Need To Know About Employee Stock Purchase Plan (ESPP)

Welcome, everyone. My name is Tan and I am an independent CERTIFIED FINANCIAL PLANNER™ practitioner. In this video, I want to focus on a tax-qualified Employee Stock Purchase Plan (ESPP) which is the most popular plan.

What is an Employee Stock Purchase Plan?
- An ESPP is a company-run program where participating employees can purchase company shares at a discounted price.
- Employees contribute to the plan through payroll deductions, which builds up between the offering date and the purchase date. At the purchase date, the company uses the accumulated funds to purchase shares in the company on behalf of the participating employees.

For example, 12 months offering period and purchase period every 6 months.
- Start payroll deduction in January, February, March, April, May, then purchase shares in June.
- Start payroll deduction in July, August, September, October, November, then purchase shares in December.
- Depending on the plan.
- Another way to structure the plan is, start payroll deduction in January, February, March, April, May, and June, then purchase shares in the same month which is June.
- Start payroll deduction in July, August, September, October, November, and December, then purchase shares in the same month which is December.

The payroll deductions occur on an after-tax basis which “means income tax and FICA taxes have already been taken out of your pay before the money is set aside for ESPP purchases (The Balance).”

Depending on the plan, the employees could get up to a 15% discount on the stock price at the offering date or the purchase date, whichever is lower. This is called a lookback.

For example, if your company’s stock price at the offering date is $100 and at the purchase date is $120. You get a 15% discount on the lower stock price which is the 15% discount on the $100. You paid $85 for the stock because of the 15% discount on the $100. If you turn around and sell it right away, that is about a 41% return ([$120 - $85] / $85 then X 100). Because it’s such a good deal, there is a cap on how much you can contribute to an ESPP.

“In most plans you may contribute up to the lower of 15% of your salary (pre-tax or after-tax depending on the company) or $25,000 each year (Wealthfront).”

Your plan description will tell you if you are contributing pre-tax or after-tax and the limits.

Cash that is not used to purchase the stock should be refunded back to you or held in the plan for future purchases.

Continuing from the previous example, the discount is always compensation income to you. Which means, you bought the share for $85 at the $100 share price. That $15 difference is compensation income to you.

$100 fair market value - $85 purchase price = $15 which is the discount and it’s the compensation income.

Remember the discount is always compensation income to you. More compensation income or not depends on your holding period when you sell the share.

Let’s say you will sell the share for $140.
- A qualifying disposition: If your holding period is greater than 2 years from the offering date and greater than 1 year from the purchase date when you sell the share, $15 ($100 - $85) is the compensation income to you plus $40 ($140 - $100) is the capital gains.

Qualifying disposition
$100 - $85 = $15 compensation income
$140 - $100 = $40 capital gains

- A non-qualifying disposition: If your holding period is 2 years or sooner from the offering date and/or 1 year or sooner from the purchase date when you sell the share, $35 ($120 - $85) is compensation income to you plus $20 ($140 - $120) is capital gains.

Non-qualifying disposition
$120 - $85 = $35 compensation income
$140 - $120 = $20 capital gains

- As you can see, it’s advantageous to have a qualifying disposition because you have less compensation income and more capital gains relative to a non-qualifying disposition.
- Normally, capital gains tax rates are lower than ordinary income tax rates.

Example 2
If your plan does not have a lookback feature and you get a 15% discount on the purchase date.
$120 X 15% discount = $18. The $18 is compensation income to you.
$120 - $18 = $102. $102 is how much you pay for the share.
Anything above $120 is your capital gains. If it’s a Qualifying Disposition.

Let’s backup the information from different sources and get into the details.

The discount is the compensation income
- Are you getting taxed as ordinary income on the discount? Yes.
- “Discount is picked up as compensation income when the shares are sold (The Balance).”
- “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 (Turbotax).”
- “You may have ordinary income if the option price was below the stock's fair market value (FMV) at the time the option was granted (IRS).”
- You are delaying tax at ordinary income rates on the 15% discount until you sell the shares.
- Although you are paying ordinary income taxes on the 15% discount, investing in ESPP is a good deal.

What is compensation income?
“Compensation income is taxed as additional wages at the ordinary income tax rates, which currently range from 10% to 39.6%. Compensation income is added to your wages and reported on Form W-2. Compensation income is subject to the federal income tax (and any state income taxes). Compensation income is not subject to Social Security and Medicare taxes (‘FICA’) (The Balance).”

Now that you have the company shares, how long you hold the shares until you sell it will give you different tax treatments.

If you sell the shares “1-year period after the stock was transferred to you, and 2-year period after the option was granted (IRS).” You have a qualified disposition.

What is a qualified disposition?
When the shares are sold at least 1 year after the purchase date (Form 3922, Line 7 Date legal title transferred) AND 2 years after the offering date (Form 3922, Line 1 Date option granted).

Another way to say it. From the grant date to the day sold = more than 2 years after the date the options were granted AND from the transfer date to the day sold = more than 1 year after the date of transfer.

- Here is an example of a qualifying disposition:
Grant date is 1/1/2019
Exercise date is 1/2/2020
Sell date is 1/3/2021

“For qualifying dispositions, compensation income is the lower of:
The fair market value of the stock on the date the option was granted, minus the price paid to exercise the option. OR
The fair market value of the stock on the date the stock was sold, minus the price paid to exercise the option (The Balance).”

Why does this matter?
- To get the lowest compensation income and highest capital gains as possible.
- Capital gains tax rates are lower than ordinary income tax rates.

Non-qualified disposition
- The shares are sold 2 years or sooner from the offering date AND/OR 1 year or sooner from the purchase date.

Why does this matter?
For non-qualifying dispositions, compensation income is:
- Fair market value of the stock on the date the option was exercised, minus the price paid to exercise the option.

Here is a really good example of a real case on a non-qualifying disposition. This example comes from myStockOptions.com, a website with educational resources on all types of stock compensation.

“My company's employee stock purchase plan (ESPP) seemed like a good deal. But I am baffled by the tax rules on my sale of the stock when I hold the shares after the purchase but not long enough to qualify for special tax treatment. At the start, the grant-date price was $10; at the end, the price was $40. So I paid just $8.50, 85% of the lower of the two prices, to buy the stock. I later sold my 500 shares at $18.50, giving me a $5,000 profit. Why am I now being told that I need to pay tax on $15,700 in compensation income?

You did not hold the ESPP stock two years from the date of grant and one year from purchase. So you owe income tax on the actual $31.50 market spread on the day of purchase ($40 - $8.50). You do have a capital loss of $10,750 ($18.50 - $40 per share x 500 shares). You can use these capital losses to offset capital gains, then write off $3,000 against your ordinary income and carry forward the unused amounts. If you had held the stock long enough and sold it at the same price, then the spread would be $1.50 ($750 total income), as it is based on the lower grant-date price of $10, with long-term capital gains of $4,250 ($18.50 - $10 x 500 shares) (FAQ 1).”

Granted price = $10
Stock price on purchase date = $40
Shares = 500

15% discount on the lower price of $10 or $40
15% discount on $10 = $8.50 purchased price
$8.50 X 500 shares = $4,250 total price purchased

Sold price = $18.50
$18.50 X 500 shares = $9,250

Total profit = $5,000 ($9,250 - $4,250)

Non-qualified disposition
$40 - $8.50 = $31.50 profit per share
$31.50 X 500 = $15,750 compensation income

If qualified disposition
$10 (grant price) - $8.50 (purchased price after 15% discount) = $1.50
$1.50 X 500 shares = $750 compensation income
$18.50 (sold price) - $10 (grant price) = $8.50
$8.50 x 500 shares = $4,250 long-term capital gains

Summary of the holding period
- Qualifying Disposition if sale date is greater than 1 year after the transfer date AND sale date is greater than 2 years after the grant date.
- Non-qualifying Disposition if sale date is 1 year or sooner after transfer date AND/OR sale date is 2 years or sooner after the grant date.
- Long Term Rates apply to the capital gains if sale date is 1 year + 1 day after the transfer date.
- Ordinary Rates apply to short-term capital gains if sale date is 1 year or sooner after the transfer date.

Form 3922 and Form 1099-B
- Form 3922 contains information about your ESPP purchases during the prior tax year. The transfer date is shown in box 7 and the grant date is shown in box 1.

- If your shares are held at E-Trade. You can get trade confirmations from E-Trade and E-Trade should give you Form 1099-B and Form 3922 so you can report it on your tax return. If you don’t get the forms, you can call and ask E-Trade for the forms.

Net Investment Income Tax (NIIT)
- Long-term capital gains are taxed at long-term capital gains tax rates and you may also be subject to the 3.8% Net Investment Income Tax.
- “Effective Jan. 1, 2013, individual taxpayers are liable for a 3.8 percent Net Investment Income Tax on the lesser of their net investment income, or the amount by which their modified adjusted gross income exceeds” $250,000 for married filing jointly (IRS 2).

Common errors are:
- Failure to report ordinary income with a qualifying disposition on your tax return.
- Paying too much in taxes because the stock basis is wrong.
- Solution: Gather all the information you can and give it to a qualified accountant.

Common questions I get all the time
- Should I contribute to my 401(k) with a match or ESPP?
- You need to run the numbers because it depends on your income, any debts, do you need the money, etc.

Strategies:
- Contribute the maximum to your ESPP because you are getting the 15% discount and normally there is a “lookback provision” on the stock price.
- Although you are paying ordinary income taxes on the 15% discount, you are getting a really good return on investment.
- You get tax deferral on the discount until the stock is sold. “With an employee stock purchase plan, nothing appears on your W-2 until you sell shares (Bal FAQ).”
- When you should sell the shares depends on your risk tolerance, your outlook of the company, do you need the money, how much is your compensation income and capital gains, etc.
- Participate to get the discount, hold the shares long enough to pay long-term capital gains on the sale of the shares, divest from a concentrated company stock position by selling the shares, and then invest in a diversified portfolio or pay down debts if there is any.
- Sometimes, it makes sense to sell the shares right away to realize the gain and pay the compensation income on the gain.

Take advantage of the volatility in the stock price
- If you can sell certain shares at a loss, it’s advantageous to sell the shares and realize the loss.

Why?
- Lower your tax burden.
- Diversifying away from a concentrated stock position.
- Converting stocks into cash.
- Capital losses offset capital gains, then up to $3,000 from capital losses can offset ordinary income then reminding losses can carry forward into the future.
- ​If you really like your company stock, you can buy it back later, but be careful of the wash sale rule.

Please note that investing involves risk and a potential loss of principal. I can’t give out tax advice, but it does not mean I can’t talk about it. Please consult with a tax professional before making an informed decision.

I hope you enjoy this video. Until next time, this is Tan. Your trusted advisor.

References:
(IRS) https://www.irs.gov/faqs/capital-gains-losses-and-sale-of-home/stocks-options-splits-traders/stocks-options-splits-traders-5
(The Balance) https://www.thebalance.com/employee-stock-purchase-plans-3192974
(Form 3922) https://www.irs.gov/pub/irs-pdf/f3922.pdf
(TurboTax) https://turbotax.intuit.com/tax-tips/investments-and-taxes/employee-stock-purchase-plans/L8NgMFpFX
(Wealthfront) https://blog.wealthfront.com/good-espp-no-brainer/
(FAQ 1) https://www.mystockoptions.com/askexpert/index.cfm/objectID/094CC17F-4CDF-4D36-8923A309F32490EA
(myStockOptions.com) https://www.mystockoptions.com/financial-planning/strategies
(myStockOptions.com FAQ) https://www.mystockoptions.com/askexpert/index.cfm
(myStockOptions.com) https://www.mystockoptions.com/ESPPs
(IRS 2) https://www.irs.gov/individuals/net-investment-income-tax

Additional Resources:
● Annual Limitations. “For options granted under an ESPP, no employee is permitted to accrue the right to purchase stock of the employer that exceeds $25,000 of the FMV of the stock (determined when the options are granted) for each calendar year in which the option is outstanding. See IRC §423(b)(3) and Treas. Reg. §1.423-2(i).”
https://www.irs.gov/businesses/corporations/equity-stock-based-compensation-audit-techniques-guide
● “A § 423 employee stock purchase plan is a type of statutory stock option plan… You don't include any amount in your gross income as a result of the grant or exercise of your option to purchase stock. You may have to report compensation on line 1a of Form 1040, U.S. Individual Income Tax Return or Form 1040-SR, U.S. Tax Return for Seniors and capital gain or loss on Schedule D (Form 1040), Capital Gains and Losses and Form 8949, Sales and Other Dispositions of Capital Assets when you sell the stock.”
https://www.irs.gov/faqs/capital-gains-losses-and-sale-of-home/stocks-options-splits-traders/stocks-options-splits-traders-4

This material is for educational use only and does not constitute tax, legal, or investment advice. Information may be changed or updated without notice. Consult with a licensed professional regarding your personal circumstances.

Please do not excerpt or copy this information without prior consent from TAN Wealth Management.