Tax Rules for a Section 423 Employee Stock Purchase Plan

An Employee Stock Purchase Plan, or ESPP, is a benefit program that allows workers to buy their company’s stock, frequently at a reduced price. These plans, specifically those designated as Section 423 plans by the Internal Revenue Code, operate under a distinct set of tax regulations. Participation means you do not have tax consequences when you are granted the option to buy stock or when you purchase it. The tax implications arise only when you sell the shares you have acquired, and the timing of your stock sale directly influences your tax responsibilities.

Key Features of a Section 423 Plan

The process begins with an “offering period,” which is a set timeframe during which employees can enroll in the plan. Once enrolled, you contribute to the plan through automatic payroll deductions over a “purchase period.” These accumulated funds are then used to buy company stock on a specific “purchase date.”

A primary benefit of these plans is the ability to purchase stock at a discount, which can be as much as 15% below the stock’s fair market value (FMV). The exact discount percentage is determined by the specific terms of your company’s plan. Many Section 423 plans also include a “lookback” provision, which can further increase the value of the discount. This feature allows the plan to use the lower of two stock prices to calculate your purchase price: the FMV at the beginning of the offering period or the FMV on the purchase date.

For example, if the stock price was $50 at the start of the offering period and $60 on the purchase date, a 15% discount would be applied to the lower $50 price. Your purchase price would be $42.50, a significant discount from the $60 market value. The Internal Revenue Service (IRS) places a limit on how much stock an employee can acquire through a qualified ESPP. In any single calendar year, an employee cannot purchase more than $25,000 worth of stock, a value determined by the stock’s FMV at the start of the offering period, not the discounted purchase price.

Calculating Your Tax Obligation

The tax treatment of stock sold from a Section 423 plan depends on how long you hold the shares before selling them. Two dates determine the holding period: the date the option to purchase was granted (the start of the offering period) and the date the stock was transferred to you (the purchase date). To receive more favorable tax treatment, you must hold the stock for more than one year after the purchase date and more than two years after the grant date. A sale that meets both of these time requirements is known as a “qualifying disposition.”

If you sell the stock without meeting both holding period requirements, the sale is considered a “disqualifying disposition.” A qualifying disposition results in a larger portion of your profit being taxed at lower long-term capital gains rates, while a disqualifying disposition treats more of the gain as ordinary income, which is typically taxed at higher rates.

Qualifying Disposition

When you execute a qualifying disposition, your profit is split into an ordinary income component and a capital gain component. The amount reported as ordinary income is the lesser of two calculations: the discount offered by the plan based on the stock’s FMV on the grant date, or the actual gain on the sale. This ordinary income portion is reported as wages on your tax return.

Consider an example: The FMV on the grant date is $100, and the plan offers a 15% discount. On the purchase date, the FMV is $120, and your actual purchase price is $85. More than two years after the grant date and one year after the purchase date, you sell the stock for $150. The ordinary income is the lesser of the $15 grant date discount ($100 x 15%) or the actual gain ($150 sale price – $85 purchase price = $65). In this case, the ordinary income is $15.

To calculate the remaining long-term capital gain, you first adjust your cost basis by adding the ordinary income ($85 purchase price + $15 ordinary income = $100). Your capital gain is the sale price minus this adjusted basis ($150 – $100 = $50).

Disqualifying Disposition

In a disqualifying disposition, the calculation for ordinary income is different. The ordinary income is calculated as the difference between the stock’s fair market value on the purchase date and the actual price you paid for the stock. This amount represents the “bargain element” and is taxed as ordinary income. Your employer will include this amount in the wages reported on your Form W-2.

Using the same numbers as before: The FMV on the purchase date is $120, and your purchase price is $85. You sell the stock for $150 before meeting the holding period requirements. The ordinary income is the difference between the FMV on the purchase date and your purchase price ($120 – $85 = $35).

To calculate your capital gain, you adjust your cost basis by adding this ordinary income ($85 purchase price + $35 ordinary income = $120). The capital gain is the sale price minus the adjusted basis ($150 – $120 = $30). This gain will be either short-term or long-term, depending on whether you held the stock for more than one year.

Information for Tax Reporting

Your employer is required to provide you with IRS Form 3922, “Transfer of Stock Acquired Through an Employee Stock Purchase Plan.” You should receive this form for the year in which the stock was purchased, and it contains information needed to calculate your taxes when you sell the shares. Key information on this form includes the grant date, the purchase date, the fair market value of the stock on both of those dates, and your actual purchase price per share.

Form 3922 is for informational purposes; you do not file it with your tax return. When you sell your ESPP shares, your broker will issue Form 1099-B, “Proceeds From Broker and Barter Exchange Transactions.” This form reports the gross proceeds from the sale.

However, the cost basis reported by the broker on Form 1099-B is often just your purchase price and does not account for the ordinary income component of your gain. You must calculate the correct, adjusted cost basis yourself. The correct basis is your original purchase price plus the amount of compensation income you must recognize from the sale. This adjustment is necessary to avoid being taxed twice on the same income.

How to Report ESPP Sales on Your Tax Return

After selling ESPP stock and calculating your ordinary income and adjusted cost basis, you must report the transaction on your tax return. The primary form for this is Form 8949, “Sales and Other Dispositions of Capital Assets.” On this form, you will detail each stock sale, reporting the proceeds from the sale as shown on your Form 1099-B and the adjusted cost basis that you calculated.

The form has specific columns to handle the adjustment if the basis you enter differs from the one reported by your broker. You will enter the basis from the 1099-B in one column and then use a separate column to make an adjustment, which will lead to your correct, higher basis.

The ordinary income component of your sale must be reported as wages on Form 1040. Your employer should include this amount in Box 1 of your Form W-2, especially in the case of a disqualifying disposition. If it is not included, you are still required to report it as “other income” on Schedule 1 of Form 1040. Once you have completed Form 8949, you will transfer the summary totals to Schedule D, “Capital Gains and Losses,” which then flows to your main Form 1040.