by Craig Pellet, EA
Stock-based compensation is popular and common. Incentive stock options, non-qualified options, restricted stock units, phantom stock plans and employee stock purchase plans (ESPPs) are some examples of the ways companies share with employees the success of the enterprise that employs them. Of these, ESPPs are the most cumbersome and complex. But they provide a way for an employee to get company stock at a discount and, if conditions are right, to pay tax at a favorable rate.
Generally, employees participating in an ESPP will have post-tax dollars withheld from their paycheck, and deposited to an account. At the end of the grant period, usually three or six months, the accumulated funds are used to purchase shares of the employer’s company at a 15% discount. The shares are generally vested immediately, so that the employee can sell them, and take the cash right away if they choose. If the company stock has held its value, such an immediate sale will turn a nice profit, because of the discount the employee received on purchasing the sold shares.
The purchase of ESPP shares is not a taxable event. Instead, tax is due upon sale of the acquired stock. As with any other sale of stock, a holding period exceeding one year will qualify for beneficial long-term capital gain rates. Short-term holdings will incur tax at higher, ordinary tax rates upon sale. For higher-income taxpayers, net investment income tax can also apply to gains. With an ESPP, an employee will almost always recognize some compensation income as well as capital gain. How much of any profit is taxed as compensation depends on the type of disposition: qualifying, or disqualifying. A qualifying disposition is one where the shares were held for over one year, and the shares were held for two years past the grant date of the options. A disqualifying disposition is a sale of ESPP shares that does not meet both of those requirements.
An employee making a disqualifying disposition will recognize compensation income at ordinary tax rates on the difference between the market value at the time of purchase, and the price actually paid for the shares, also known as the spread. This income is added to the employee’s Form W-2 in the year of sale. Any additional gain is either long-term or short-term, depending on the holding period of the sold shares.
A qualifying disposition has the potential for a smaller spread, and thus lower tax. The compensation element of a qualifying disposition is the lesser of the market value at time of purchase, minus the actual purchase price of the sold shares; or the market value at the beginning of the grant period, minus the purchase price of the shares. The spread will be reported on the employee’s Form W-2. Any gain beyond the compensation element will be subject to tax at long-term capital gains rates.
Generally, a taxpayer cannot recognize more combined compensation income and capital gain than the total economic gain. Thus, if the total economic gain was less than the option spread, the compensation income will be limited to the total economic gain, and there will be no capital gain or loss.
When an employee exercises options, the issuing employer must report the information needed to calculate the type and amount of gain on sale on Form 3922. An employee gets this information when buying shares – not when selling them. It is very important for taxpayers to keep every form. Often brokers and employers will make errors in reporting taxable income on Form W2 and Form 1099-B. It is important for taxpayers to review information from the Form 3922, and their plan reports to ensure that their income is properly reported.
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