Reporting ESPP taxes

I know taxes are due any day now and you are wondering what the heck to do with your ESPP tax reporting. Maybe you’ve been participating in your companies ESPP for years or got started recently. Either way, an understanding of how to deal with ESPP tax reporting is important and it also highlights how great of an opportunity you have because an ESPP is available for you to participate in. If you haven’t started investing in your company ESPP – you should go read You have an ESPP now what, then learn to configure your account for selling ESPP shares, then read up on what to do with all those dividends and option premiums in your ESPP account, and finally read this article on how to report the profits on your taxes.

Let’s recap where we are at, you are investing in an employee stock purchase plan. At the beginning of the stated ESPP period, you are electing to have your cash withheld from your paycheck (essentially deferring after-tax compensation). On the last day of the period, the money you told your employer to set aside is used to purchase shares of ownership in the company that you work for. This part is a little different for every company. For example Comcast and HP have different standards for calculating their respective stock prices and they have different discount levels they let you buy in at. More specifically – Microsoft’s ESPP program let’s you elect to withhold up to 15% of your earnings and at the end of their three month period, they purchase (on your behalf) as many shares as they can at a 10% discount (or a purchase price equal to market price * 90%).

This discount is the core component that we need to worry about for tax purposes. Before we jump into it though, I’ll let you in on a little secret. Nearly every wealthy person in the country uses tax advantaged wealth management strategies. The secret is that most major companies in the US (including UPS, Wells Fargo, EMC, HP, etc.) offer these same strategies to all of their employees. The tax code (§ 423 of the Internal Revenue Code) that allows the ESPP to exist also allows for a special tax treatment. This means that anyone working for a company that offers an ESPP has the opportunity to implement a strategy used by all 1%’ers.

When you elect to withhold your pay and have your employer purchase ESPP shares for you at a discount, § 423 states that you are not subject to income tax at the time the ESPP shares are purchased. So if you are getting shares at a 10% discount (as is the case with Microsoft), you just made a 10% return without paying ANY taxes. You have moved a portion of your income into an account, earned a 10% return, and skipped out on the income tax of the 10%!! Now you are on your way to becoming filthy rich – right?

Well not so fast. You do have to pay taxes at some point on this money. Keep reading to find out when you pay the taxes, how you calculate them, and of course how to pay the minimum amount possible.

It may be obvious, but you pay these taxes at the point in time that you sell the shares. Which means that you need to figure out the least amount of taxes you can possibly pay on those shares so that you earn more money than you would have earned if your employer just gave you a 10% bonus.

The way to figure this out is to determine if you are selling the shares as a disqualified sale or a qualified sale. These are goofy names for a pretty straight forward concept.

  • Qualified sale – hold the shares for two years or more, pay less taxes
  • Disqualified sale – hold the shares for less than two years, pay more taxes

 

It doesn’t really get any simpler than that. It is pretty easy to determine which of the two categories you want to be in. It is also pretty easy to determine how you can put yourself into the category that you want to be in.

Let’s start with the expensive disqualified sale category. If you fall into this category, you have sold your shares before two years has gone by. The two year period is from the beginning of the ESPP participation period to the date of sale. So if you elected to participate in your ESPP plan period that started on January 1 2012 and you are looking to sell your shares today (middle of March 2013), you would be nearly 15 months into the 24 month time span even though you didn’t actually own the shares until some point after January 1 in 2012. For example if your ESPP participation period is 3 months, you would have only had the shares in your possession for 12 months; however, the IRS started counting from the date that you elected to participate in the plan – another BONUS for you!!

Back to the bad news though, if you are selling before the full 24 months is up, you will pay ordinary income tax based on your tax bracket on the purchase discount (10% in our example) and you will be subject to capital gain/loss taxes on any profits that you earn beyond the 10% discount. These capital gains will be just like any other capital gain from a stock sale, meaning they will be long term capital gains if you hold the shares for longer than a year and short term capital gains if you hold them for less than a year.

Ok, I get that is a lot to walk through… let’s walk through an example.

We’ll keep using a 10% purchase discount and we’ll use share prices of $100 to make the math easy. Let’s assume that you are selling at a price that is higher than the initial price and that your ESPP purchase period is three months. Further we’ll assume we are starting at January 1 2012 for the ESPP purchase period.

  • Price at the beginning of the ESPP purchase period (1/1/2012): $100
  • Price of the shares at the end of the ESPP purchase period (3/31/2012): $110
  • Price of the shares after your 10% discount (3/31/2012): $99
  • Sale Price: $150
  • Total Gain/Loss: $51

If this is a Disqualifying sale, you have sold the shares before 1/1/2014.

  • Ordinary Income: $11 ((10% of 110)*1 Share = $11)
  • Capital Gain/Loss: $40 ((150 – 110)*1 Share = $40

If this is a Qualifying sale, you have sold the shares after 1/1/2014.

  • Ordinary Income: $10 (the lesser of: ((10% of 100)*1 Share = $10) or ((150-99)*1Share = $51))
  • Capital Gain/Loss: $41 ((150-(99+10))*1Share = $41)

 

Now for the good stuff with the qualified sale category. If you fall into this category, you have sold your shares after two years has gone by. You will pay the same income tax on whatever amount is left of your discount and your capital gains will be long term capital gains which should provide you a much lower tax rate than the ordinary income tax rate.

Let’s walk through another example to make it clearer. We’ll continue the same example where the price at the beginning of the ESPP period is $100, the end price (market value at the time of purchase) is $110, and your purchase price is $99. This time, let’s look at how the sale price of $95 works out.

  • Price at the beginning of the ESPP purchase period (1/1/2012): $100
  • Price of the shares at the end of the ESPP purchase period (3/31/2012): $110
  • Price of the shares after your 10% discount (3/31/2012): $99
  • Sale Price: $95
  • Total Gain/Loss: ($4)

If this is a Disqualifying sale, you have sold the shares before 1/1/2014.

  • Ordinary Income: $11 ((10% of 110)*1 Share = $11)
  • Capital Gain/Loss: ($15) ((95 – 110)*1 Share = ($15)

If this is a Qualifying sale, you have sold the shares after 1/1/2014.

  • Ordinary Income: $0 (the lesser of: ((10% of 100)*1 Share = $10) or ((95-99)*1Share = ($4)))
  • Capital Gain/Loss: ($4) ((95-(99+0))*1Share = ($4))

 

Regardless of which category you fall in, you have to report this stuff to the IRS. The trouble of course is that this ordinary income is tough to sort out for individuals as it is not reported in a consistent manner. Usually if you are selling as a disqualified sale, the income is reported on your W-2. If you are selling as a qualified sale, the income is reported on a 1099 by Fidelity or whomever is your broker. This means that if you sell you are selling a disqualified position, Fidelity or your broker will give you details on the capital gain/loss for the sale, but will use the post-discount price as the basis for the shares. You would then need to look on your W-2 for the reported income to account for the 10% discount. This isn’t exactly intuitive and when you look at the 1099 that Fidelity or your broker sends you it doesn’t explicitly state which price is being used as the basis for the shares. I think this is why so many people have problems with doing taxes when they have an ESPP. To make matters worse, Fidelity and other brokers don’t always report what you are receiving as income and what you are receiving as capital gain/loss leaving it up to you to do the math entirely.

Clearly relying on your broker to tell you how much money you made is a bad idea. You should keep your own spreadsheet to track this information if you truly want to know the answer. You can dump all of these examples into a spreadsheet and compare your ESPP purchases/sales against the examples. If you like feel free to send me an email or leave a comment and I’ll be happy to send you a copy of the spreadsheet I use to track my sales.

Here is another example – you really need to understand every scenario if you are going to report your taxes correctly. We’ll continue with the same premise as the other examples; however, now we’ll switch to the scenarios where the price at the beginning of the ESPP period is higher than the stock at the end of the ESPP period. Yes I am talking about the scenario where you elect to have your company buy shares on your behalf when the price of your shares are higher and then the price falls just in time for the purchase to occur.

This time the price at the beginning of the ESPP period is $110, the end price (market value at the time of purchase) is $100, and your purchase price is $90. This time, let’s look at how the sale price of $95 works out.

  • Price at the beginning of the ESPP purchase period (1/1/2012): $110
  • Price of the shares at the end of the ESPP purchase period (3/31/2012): $100
  • Price of the shares after your 10% discount (3/31/2012): $90
  • Sale Price: $95
  • Total Gain/Loss: $5

If this is a Disqualifying sale, you have sold the shares before 1/1/2014.

  • Ordinary Income: $10 ((10% of 100)*1 Share = $10)
  • Capital Gain/Loss: ($5) ((95 – 100)*1 Share = ($5)

If this is a Qualifying sale, you have sold the shares after 1/1/2014.

  • Ordinary Income: $5 (the lesser of: ((10% of 110)*1 Share = $11) or ((95-90)*1Share = $5))
  • Capital Gain/Loss: $0 ((95-(90+5))*1Share = $0)

 

At this point you may be wondering how paying income tax on your discount at a later date is a good strategy. If you think about it another way, you are getting a bonus equal to the discount and you don’t have to pay taxes on the bonus at the time you get the bonus. Imagine if you were to get your 10% annual bonus and didn’t have to pay any taxes on it until a date that you choose? That seems like a dream come true – yet it isn’t readily obvious or explicitly stated by your company when you sign up for the ESPP. Beyond the ability to choose when you pay the income tax on your bonus, you are not paying the federal payroll taxes. That’s right – a loophole that was not closed with the tax changes that have been recently put into place. A tax loophole that people in the middle class can easily take advantage of.

Let’s walk through one last example as I’m sure you are still thinking of another scenario I didn’t specifically cover. This time the price at the beginning of the ESPP period is $110, the end price (market value at the time of purchase) is $100, and your purchase price is $90. This time, let’s look at how the sale price of $150 works out.

  • Price at the beginning of the ESPP purchase period (1/1/2012): $110
  • Price of the shares at the end of the ESPP purchase period (3/31/2012): $100
  • Price of the shares after your 10% discount (3/31/2012): $90
  • Sale Price: $150
  • Total Gain/Loss: $60

If this is a Disqualifying sale, you have sold the shares before 1/1/2014.

  • Ordinary Income: $10 ((10% of 100)*1 Share = $10)
  • Capital Gain/Loss: $50 ((150 – 100)*1 Share = $50

If this is a Qualifying sale, you have sold the shares after 1/1/2014.

  • Ordinary Income: $11 (the lesser of: ((10% of 110)*1 Share = $11) or ((150-90)*1Share = $60))
  • Capital Gain/Loss: $49 ((150-(90+11))*1Share = $49)

 

Did you notice the theme in every single example (except for the last one)? You always earn the same amount of money; however, the tax treatment pushes the taxable income on a qualified sale lower than the taxable income on a disqualified sale. In all three of those cases, the capital gain/loss is also more advantageous in the qualified sale vs. the disqualified sale.

That’s it… there isn’t much more to getting free money and actually reporting a portion of the free money on your taxes. There are some other considerations if you are going to give those ESPP shares away (especially if you are giving those shares to a charity). Yet, this post is long enough already so I’ll save the treatment of gifting the ESPP shares to other people or to charitable organizations for another post.

  • Evelyn

    This was a very informative article! Have you also discussed the potential tax consequences of holding onto your employee shares and directly donating them to a qualified public charity?

  • http://www.joshuamaher.com/ Joshua Maher

    That is an interesting thought Evelyn, I have not calculated things like donation to charity, etc. I have looked at long term holding of course. The big risk there though is over-exposure to your employer (e.g. if the company fails you lose your income stream and your savings).
    I really like the charitable giving idea! I’ll work on the charitable giving aspect for my next ESPP post in June.

  • robtpenn

    Thanks. This is the first explanation I read that I “sort of” understood. The down side for me is that my employer reports their contribution to the ESPP on Form W2 each year. So, if I have $10,000 withdrawn for the ESPP, they contribute ~ $1,760 to my ESPP plan and report it each year in Box 1 on the W2 as Salaries and Wages. The part I’m still unsure of is, based on how my employer handles this do I still need to hold the shares 2 years from the grant date to qualify for LT cap gains treatment?

  • http://joshmaher.net Josh Maher

    Glad this is helpful Rob, feel free to ask any other clarifying questions.

    The reporting is always the trick with these, employers and brokers don’t usually make it easy. Usually the employer reports on the W2 as salary anything that they can guarantee is ordinary income which would be only the discount on the shares.

    Regardless of how the ESPP discount is reported – you need to hold the shares for the 2yrs (from the start of the ESPP period) before the profits/losses from selling them will be available for LT cap gains.

  • Patrick Kenny

    Thanks for the detailed explanation. I’d love to have a look at that spreadsheet to help manage these ESPP details. I’m looking at a qualified sale of Microsoft ESPP stock, and I had a few other questions. Since this is qualified (>2 years), the wage portion doesn’t show up on the W-2 and I have to derive the wage portion vs capital gains myself, right?
    Is the Form 3922 the correct place to look for the fmv and exercise price?
    Is there any discount applied to stock acquired through dividend reinvestment since the dividends were accrued from stock purchased at a discounted price?
    Unfortunately, I only have 3922 forms back to 2010 and looking at selling ESPP MSFT stock acquired as early as 2008–you wouldn’t happen to have that data, would you?

  • http://www.joshuamaher.com/ Joshua Maher

    Good questions Patrick! I’ll send you the spreadsheet. To answer your questions though:

    There is no discount applied to dividend reinvestment – you only get the discount once.
    You are correct, Form 3922 will show the cost basis. Your fidelity statement should also show this so you could look at the data from fidelity to get back to 2008.

  • Karen

    Hello Josh, I just found this blog post because my Turbo Tax deluxe version does not ask about our ESPP sales.
    As far as I can tell, our sales are qualified, but I have no clue regarding the discount part. I do have Form 3922 from 2011 and would like to try your spreadsheet to help manage our ESPP. Merrill Lynch transfers all ESPP acquisitions to our Scottrade acct, where the selling commissions are much cheaper. Don’t know if this makes a difference.
    Thank you for your help!

  • Lisa Dorman Miller

    Can you please email me your spreadsheet?
    5472miller@comcast.net
    Thank you!!
    Lisa

  • zfan

    Test

  • Nishan Bhajari

    Hi Josh: Could you please send me the spreadsheet? My email is njb2226 at gmail. Much appreciated and thanks in advance.

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