ESPPs and the IRS: How to Report Taxes

An Employee Stock Purchase Plan (ESPP) is a company-run program in which participating employees can purchase company stock at a discounted price. Employees contribute to the plan through payroll deductions over an offering period. At the end of this period, the accumulated funds are used to buy stock in the company on behalf of the participating employees. While the opportunity to buy shares for less than their market value is a benefit, it introduces complexities regarding federal income tax. The tax implications are not immediate upon enrollment but are triggered by specific events in the lifecycle of the stock ownership.

Key ESPP Tax Events

The tax treatment of your ESPP shares is tied to a specific timeline of events. The first date is the “Grant Date,” which marks the beginning of the offering period. This is the date your employer allows you to start making contributions from your paycheck to purchase future shares. No tax is due at this point; it simply sets the terms of the purchase.

The next event is the “Purchase Date.” This is the day your accumulated payroll deductions are used to buy the company stock at the predetermined discount. The difference between the fair market value (FMV) of the stock on the purchase date and the price you pay is known as the “bargain element.” This bargain element is the foundation of the ordinary income you will eventually report, though no tax is owed on the purchase date for a qualified ESPP.

The final event for tax purposes is the “Sale Date.” This is the date you sell your ESPP shares, which triggers the tax liability. The amount and type of tax you owe depend on the timing of this sale relative to the grant and purchase dates.

Qualifying vs. Disqualifying Dispositions

The way your ESPP stock sale is taxed hinges on whether it is classified as a “qualifying disposition” or a “disqualifying disposition.” The classification is determined by how long you hold the stock before selling it. A qualifying disposition receives more favorable tax treatment.

To achieve a qualifying disposition, you must meet two holding period rules. First, you must sell the shares more than two years after the grant date. Second, the sale must also occur more than one year after the purchase date. Satisfying both conditions allows a portion of your profit to be taxed at lower long-term capital gains rates, while a smaller component is treated as ordinary income.

Any sale that fails to meet both holding period requirements is considered a disqualifying disposition. This means if you sell the stock less than two years after the grant date or less than one year after the purchase date, the sale is disqualifying. In this scenario, a larger portion of your gain is taxed as ordinary income, which is subject to higher tax rates.

Calculating Your Taxable Income

Tax Calculation for a Qualifying Disposition

When you meet the holding period for a qualifying disposition, your taxable income is split into two parts: ordinary income and capital gain. The ordinary income component is the lesser of two amounts: the bargain element on the grant date or the actual gain on the sale. Your employer will report this amount as compensation on your Form W-2. The remaining portion of your profit is treated as a long-term capital gain.

To calculate the capital gain, you first determine your adjusted cost basis. Your cost basis is the price you paid for the stock plus the amount of ordinary income recognized on the sale. The capital gain is then the difference between your total sale proceeds and this adjusted cost basis. This gain is taxed at long-term capital gains rates.

Tax Calculation for a Disqualifying Disposition

In a disqualifying disposition, the tax calculation often results in a higher tax liability. The ordinary income portion is the full bargain element calculated on the purchase date. This is the difference between the stock’s fair market value on the day it was purchased and the discounted price you paid. This amount is considered compensation and is taxed at your regular ordinary income tax rates.

Any additional profit from the sale is treated as a capital gain. To calculate this gain, you establish your adjusted cost basis by adding the ordinary income amount to your original purchase price. The difference between your sale proceeds and this adjusted basis is your capital gain or loss. The character of this gain—short-term or long-term—depends on whether you held the stock for one year or less from the purchase date.

Required Tax Forms for ESPPs

Your employer and brokerage firm will provide several forms containing the information to report your income. It is important to note that the cost basis reported on Form 1099-B is often incorrect for ESPP sales because it reflects only what you paid for the shares and not the ordinary income component you must add to it.

• Form 3922, Transfer of Stock Acquired Through an Employee Stock Purchase Plan: Your employer sends this for the year the stock was purchased. This informational form is for your records and contains all key figures, including the grant date, purchase date, fair market value on both dates, and the purchase price per share.
• Form W-2, Wage and Tax Statement: The ordinary income portion of your sale will be included as wages on your W-2, typically in Box 1.
• Form 1099-B, Proceeds from Broker and Barter Exchange Transactions: You will receive this from the brokerage that handled the sale. This form reports the gross proceeds from the sale but will list an incorrect cost basis.
• Form 8949, Sales and Other Dispositions of Capital Assets: You will use this form to report the details of the stock sale to the IRS and make necessary adjustments to the cost basis.
• Schedule D, Capital Gains and Losses: The totals from Form 8949 are carried over to this form to reconcile your tax liability.

Step-by-Step Guide to Reporting the Sale

The final step is to report the sale of your ESPP shares correctly on your tax return, which centers on Form 8949. This form requires you to detail each stock sale, and for ESPP transactions, it involves a basis adjustment to prevent double taxation. You must not simply copy the information from your Form 1099-B.

Begin by transcribing the sale details from your Form 1099-B onto Form 8949, including the description of the property, dates of acquisition and sale, and the sales price. The most important step involves column (e), the cost basis. You must adjust the basis reported on your 1099-B by adding the amount of ordinary income that was reported on your W-2.

In column (f) of Form 8949, you will enter code “B” to signify that the basis reported by the broker is incorrect. In column (g), you will report the amount of the adjustment, which is the ordinary income component you added to the basis. The corrected basis in column (e) will then be the sum of the price you paid for the stock and the compensation income recognized. The final calculated gain or loss from Form 8949 is then transferred to Schedule D.