How Is an Employee Share Purchase Plan Taxed?

An employee share purchase plan, or ESPP, is a company-sponsored benefit that allows employees to buy shares of their company’s stock, often at a discounted price. These plans are designed as an incentive, helping employers attract and retain talent by giving them a stake in the company’s success. Participation is funded through payroll deductions that accumulate over a set period and are then used to purchase stock.

Key Features and Enrollment

An ESPP operates through offering periods, which is the timeframe employees can enroll and contribute funds. Within an offering period, there are one or more purchase dates when the accumulated deductions are used to buy company stock. Funds are collected through after-tax payroll deductions, meaning the money is taken from a paycheck after income taxes have been withheld.

A significant appeal of these plans is the ability to purchase stock at a discount of up to 15% below its fair market value. Many plans also include a “lookback” provision. This feature calculates the purchase price discount based on the lower of the stock’s price at the start of the offering period or on the purchase date, potentially increasing the employee’s gain.

The Internal Revenue Service (IRS) imposes an annual limit, stating that an employee cannot purchase more than $25,000 worth of stock in any calendar year. This value is calculated based on the stock’s fair market value at the beginning of the offering period, not the discounted price.

During an open enrollment window, employees receive plan documents and can join by completing an enrollment form. On the form, the employee specifies the percentage of pay they wish to contribute. This amount is then automatically deducted from each paycheck for the duration of the offering period.

Understanding ESPP Taxation

The tax treatment of an ESPP depends on whether it is a “qualified” or “non-qualified” plan. Most ESPPs are qualified, meaning they meet the requirements of Internal Revenue Code Section 423 and receive favorable tax treatment. For a qualified plan, no tax is due when the shares are purchased; the tax event is deferred until the shares are sold.

In contrast, a non-qualified ESPP has different tax consequences. For these plans, the discount on the stock purchase is considered compensation income at the time of purchase. This amount is immediately taxable as ordinary income and is subject to payroll taxes.

Tax Implications of Selling Shares

The tax outcome of selling ESPP shares depends on the holding period. A “qualifying disposition” provides more favorable tax treatment and occurs if the sale meets two requirements: the shares are sold more than two years after the offering date and more than one year after the purchase date. In this scenario, a portion of the profit is taxed as ordinary income, and the rest is a long-term capital gain.

For a qualifying disposition, the amount reported as ordinary income is the lesser of two figures: the original discount offered or the total profit from the sale. The remaining gain is taxed at long-term capital gains rates. For example, if the discount was $5 per share and the total gain was $20 per share, $5 is taxed as ordinary income and the remaining $15 as a long-term capital gain.

Any sale that fails to meet both holding period requirements is a “disqualifying disposition.” For this type of sale, the ordinary income component is the spread between the stock’s fair market value on the purchase date and the discounted price paid. This amount is taxed as regular income.

The remaining gain or loss from a disqualifying disposition is a capital gain or loss. If the shares were held for one year or less from the purchase date, the gain or loss is short-term. If held for more than a year, it is long-term. For instance, if the market price was $30 on the purchase date and the employee paid $25, the $5 difference is ordinary income. If the stock is sold for $32, the additional $2 is a short-term capital gain.

Reporting ESPP Transactions on Your Tax Return

When you sell ESPP shares, the transactions must be reported on your federal tax return. Your employer provides Form 3922, which contains the offering date, purchase date, purchase price, and fair market values needed to calculate your tax liability.

The ordinary income portion of your sale is reported as wages. For a disqualifying disposition, your employer will include this amount in Box 1 of your Form W-2. Some employers also report the ordinary income from a qualifying disposition on the W-2.

You will also receive Form 1099-B from the brokerage that handled the sale. The cost basis reported on this form is often just the discounted purchase price. If you do not adjust this figure, you risk being taxed twice on the same income—once as ordinary income and again as a capital gain.

To report the sale correctly, use Form 8949, Sales and Other Dispositions of Capital Assets. On this form, report the sale proceeds from your 1099-B and then report the correct cost basis. The correct basis is the original purchase price plus the amount of ordinary income you recognized. The difference between the sale price and this adjusted basis is your capital gain or loss, which flows to Schedule D.