Are ESPP Contributions a Tax Deduction?

An Employee Stock Purchase Plan (ESPP) is a company-run program allowing employees to buy company stock at a discount. Participation is facilitated through payroll deductions over a set “offering period.” These plans have specific tax rules that differ from other savings vehicles, and understanding them is important for maximizing their financial benefits.

Understanding ESPP Contributions

A common point of confusion is the nature of ESPP contributions. When you enroll, a percentage of your salary is set aside through payroll deductions, but these contributions are made with after-tax dollars. This means the money used to purchase the stock has already been taxed as part of your regular earnings.

Unlike a traditional 401(k), where pre-tax contributions lower your taxable income, ESPP contributions are not tax-deductible. The deduction on your pay stub is for funding the stock purchase, not for reducing your tax liability. The tax implications of an ESPP arise only when you sell the shares, not when you contribute money or purchase the stock.

Tax Treatment Upon Sale of ESPP Stock

The tax treatment of profits from an ESPP sale is determined by how long you hold the stock. The Internal Revenue Service (IRS) defines a sale, or “disposition,” as either qualifying or non-qualifying based on two holding periods.

To achieve a qualifying disposition, the sale must occur more than one year after the purchase date and more than two years after the grant date (the start of the offering period). Meeting both conditions results in more favorable tax treatment. If either holding period is not met, the sale is a non-qualifying disposition, and the profit is taxed differently. Portions of the gain will be treated as either ordinary income or capital gains, which are subject to different tax rates.

Qualifying Disposition

With a qualifying disposition, the tax calculation is split into two parts. The first part is ordinary income, calculated as the lesser of two amounts: the actual gain from the sale or the discount offered on the grant date. Any remaining profit is treated as a long-term capital gain, which is taxed at a lower rate than ordinary income.

For example, your company’s stock was $50 on the grant date with a 15% discount, making your purchase price $42.50. You later sell the shares for $70, for a total gain of $27.50 per share. The ordinary income portion is the lesser of the actual gain ($27.50) or the original discount ($7.50), so $7.50 per share is taxed as ordinary income, and the remaining $20.00 is a long-term capital gain.

Non-Qualifying Disposition

In a non-qualifying disposition, the portion of your gain taxed as ordinary income is the “bargain element.” This is the difference between the stock’s fair market value (FMV) on the purchase date and the discounted price you paid. This amount is taxed at your regular income tax rate.

Any additional profit is a capital gain. If you held the stock for one year or less, it is a short-term capital gain; if held for more than one year, it is a long-term capital gain. For instance, the stock’s FMV was $60 on the purchase date, and you paid $51. You sell it a few months later for $70. The $9 bargain element ($60 – $51) is taxed as ordinary income, and the remaining $10 of profit ($70 – $60) is a short-term capital gain.

Required Information for Tax Reporting

Accurate reporting requires specific documents. Your employer provides Form 3922, Transfer of Stock Acquired Through an Employee Stock Purchase Plan, for the year you purchase shares. This informational form contains data for your calculations, including grant and purchase dates, purchase price, and the stock’s FMV on those dates.

When you sell, your brokerage issues Form 1099-B, which reports the sale proceeds. However, the cost basis reported on Form 1099-B is often incorrect for ESPP sales, as it only shows your discounted purchase price. This can lead to being taxed twice on the same income.

To avoid this, you must calculate the correct cost basis by adding the ordinary income portion of your gain to your purchase price. The ordinary income amount is reported by your employer on your Form W-2.

How to Report an ESPP Sale on Your Tax Return

The final step is reporting the sale on your tax return using Form 8949, Sales and Other Dispositions of Capital Assets. You will use the information from Form 1099-B to report the sale proceeds but must make an adjustment to the cost basis.

On Form 8949, enter the sale details from your Form 1099-B. In column (e), enter the corrected cost basis you calculated previously. In column (f), enter adjustment code “B” to indicate the basis reported on Form 1099-B was incorrect.

The totals from Form 8949 are then carried over to Schedule D, Capital Gains and Losses. This process ensures the ordinary income portion of your gain is not improperly taxed as a capital gain.