Tax on Transfer of Stock from an Employee Stock Purchase Plan

An Employee Stock Purchase Plan (ESPP) allows employees to buy company stock, often at a discount, through payroll deductions. The tax implications of these plans are not triggered upon purchase but arise when the employee sells or otherwise transfers the stock. How long the shares are held is a primary factor in determining the tax treatment, which dictates how much profit is treated as regular income versus capital gains.

Key Terminology and Holding Periods

The tax treatment of stock sold from an ESPP hinges on whether the sale is a “qualifying disposition” or a “disqualifying disposition.” A qualifying disposition meets specific holding period requirements and generally results in a more favorable tax outcome. A disqualifying disposition is any sale of ESPP shares that fails to meet these time-based criteria.

To achieve a qualifying disposition, two holding period tests must be satisfied. The stock must be sold more than two years after the grant date, which is the first day of the offering period. The stock must also be sold more than one year after the purchase date, the day the company used employee contributions to buy the shares.

For an offering period that begins on January 1, 2023 (the grant date), and a stock purchase on June 30, 2024 (the purchase date), the employee must not sell the shares before July 1, 2025. This date is more than two years after the grant date and more than one year after the purchase date. Selling before this date would result in a disqualifying disposition.

Tax Consequences of a Qualifying Disposition

When you sell ESPP shares in a qualifying disposition, your profit is split into two components: ordinary income and long-term capital gain. The portion taxed as ordinary income is the lesser of two figures: the gain realized on the sale (sale price minus your purchase price) or the discount offered on the grant date. The grant date discount is the difference between the stock’s fair market value (FMV) on the grant date and the discounted price.

Any profit remaining after accounting for the ordinary income portion is treated as a long-term capital gain. These gains are typically taxed at lower rates than ordinary income, which is the tax benefit of meeting the holding period requirements.

Suppose the stock’s FMV on the grant date was $50, and you purchased it for $42.50. If you later sell it for $80 in a qualifying disposition, the ordinary income is the lesser of the actual gain ($37.50) or the grant date discount ($7.50). Therefore, $7.50 of your profit is taxed as ordinary income, and the remaining $30 is taxed as a long-term capital gain.

Tax Consequences of a Disqualifying Disposition

In a disqualifying disposition, a portion of your gain is treated as ordinary income based on the “bargain element”—the difference between the stock’s Fair Market Value (FMV) on the purchase date and your discounted purchase price. This amount is taxed as compensation income. To find your capital gain or loss, you adjust your cost basis by adding the ordinary income amount to your original purchase price.

The capital gain or loss is short-term if you held the stock for one year or less from the purchase date. If you held it for more than one year, it is long-term. This is true even if the sale is a disqualifying disposition because you failed the two-year-from-grant-date test.

For instance, assume the FMV on the purchase date was $60, and you paid $51. You sell the shares for $70 six months later. The ordinary income component is the $9 bargain element ($60 – $51). Your adjusted basis becomes $60 ($51 + $9), and the capital gain is $10 ($70 – $60). Since you held the stock for less than a year, this $10 is a short-term capital gain.

Reporting the Transfer on Your Tax Return

Your employer will provide Form 3922, “Transfer of Stock Acquired Through an Employee Stock Purchase Plan,” which details the grant date, purchase date, FMVs, and your purchase price. After the sale, your brokerage firm will issue Form 1099-B, “Proceeds from Broker and Barter Exchange Transactions,” which reports the sale proceeds.

A common issue with Form 1099-B is that the cost basis reported is often incorrect for tax purposes. The broker typically reports only your out-of-pocket purchase price and does not account for the ordinary income component you must recognize. This means the gain shown on Form 1099-B is usually overstated, and you must make an adjustment on your tax return to avoid overpaying taxes.

The correct reporting takes place on Form 8949, “Sales and Other Dispositions of Capital Assets.” You report the transaction as shown on your Form 1099-B. To correct the basis, you enter code “B” in column (f) and enter the amount of ordinary income you calculated in column (g) as a positive adjustment.

This adjustment on Form 8949 increases your cost basis, reducing your capital gain to the correct amount. The totals from Form 8949 are then carried over to Schedule D, “Capital Gains and Losses.” The ordinary income portion of your gain must also be reported as “other income” on Schedule 1 of Form 1040 if it was not already included in the wages on your Form W-2.

Special Transfer Scenarios

Gifting ESPP stock is a taxable event for you, the giver. You must recognize ordinary income equal to the bargain element (the spread between the stock’s FMV on your purchase date and your purchase price), as if it were a disqualifying disposition. The recipient’s basis becomes your original purchase price plus the ordinary income you recognized.

If stock is transferred due to the employee’s death, the ordinary income recognition rules do not apply. The bargain element that would have been taxed as compensation is forgiven. The beneficiary receives a “stepped-up basis,” meaning their basis is the stock’s fair market value on the date of death, which can reduce or eliminate their future capital gains tax.