What Are the Tax Rules for IRS Section 423 Plans?

An Employee Stock Purchase Plan (ESPP), operating under Internal Revenue Code Section 423, is a benefit that allows employees to purchase shares of company stock at a discounted price. Contributions are made through payroll deductions over a set period. The appeal of these plans lies in the potential for favorable tax treatment upon the eventual sale of the stock.

This tax treatment is contingent upon meeting specific holding period requirements defined by the IRS. If these rules are followed, a portion of the profit from the stock sale may be taxed at lower long-term capital gains rates instead of higher ordinary income rates. The structure of these plans is regulated to ensure they are offered broadly to employees, preventing them from being exclusive to high-level executives.

Plan Qualification Requirements

For an ESPP to receive tax-advantaged status under Section 423, the plan must adhere to rules established by the IRS. A foundational requirement is that the plan must be a formal written text approved by the company’s shareholders. This approval formalizes the terms under which the stock will be offered to employees.

A qualified plan must be non-discriminatory, meaning the option to participate must be granted to all full-time employees. The plan can exclude certain groups, such as employees who have been with the company for less than two years or those who work 20 hours or less per week. Any employee who owns 5% or more of the company’s stock is also barred from participation.

All participants in the plan must have the same rights and privileges, and the terms of the stock offering cannot favor highly compensated employees. The discount offered on the stock purchase must be applied equally for all participating employees. The purchase price formula must be consistent for everyone enrolled in a specific offering period.

There is a monetary limit on how much stock an employee can acquire through the plan in a given year. An employee cannot accrue the right to purchase more than $25,000 worth of stock for each calendar year the option is outstanding. This value is determined based on the stock’s fair market value when the offering period begins, not the discounted price.

Employee Participation and Stock Purchase

Participation in a Section 423 plan begins with an “offering period.” This is a pre-determined length of time, often lasting from six to 24 months, during which the company offers its stock for purchase. To participate, an eligible employee enrolls and authorizes the company to make after-tax payroll deductions, which accumulate over the offering period.

The amount an employee contributes is a percentage of their salary, subject to plan-specific maximums. At the end of the offering period, on the “purchase date,” the company uses the employee’s accumulated funds to buy shares on their behalf. The number of shares purchased is determined by the total amount contributed and the purchase price per share.

Many Section 423 plans include a “lookback” provision, which can enhance the value of the discount. With a lookback, the purchase price is discounted from the stock’s fair market value on either the grant date (the first day of the offering period) or the purchase date (the last day), whichever is lower. This feature is advantageous in a rising market, as it allows employees to purchase stock at an earlier, lower price.

For example, if a plan offers a 15% discount and a lookback provision, and the stock price is $20 on the grant date and $30 on the purchase date, the purchase price is based on the lower $20 value. The purchase price would be $17 (a 15% discount from $20), even though the stock is trading at $30. This mechanism provides a built-in advantage.

Tax Treatment of Stock Dispositions

The tax implications of selling stock acquired through a Section 423 plan depend on how long the shares are held. For the most favorable tax outcome, two holding periods must be met: the stock must be held for at least two years from the offering’s grant date, and for at least one year from the purchase date. A sale that meets both of these conditions is known as a “qualifying disposition.”

In a qualifying disposition, the tax calculation involves ordinary income and long-term capital gain. The amount reported as ordinary income is the lesser of two figures: the discount offered by the plan based on the stock’s value on the grant date, or the actual gain on the sale. The remainder of the profit is treated as a long-term capital gain. For instance, if an employee buys stock with a grant date value of $50 and a purchase price of $42.50, and sells it for $70 after meeting the holding periods, the ordinary income is $7.50 per share. The remaining $20 of the gain is taxed as a long-term capital gain.

If either of the two holding period requirements is not met, the sale is considered a “disqualifying disposition.” This results in a less favorable tax treatment. In this case, the amount of ordinary income is calculated as the difference between the stock’s fair market value on the purchase date and the discounted price the employee paid. This amount is considered compensation income.

For a disqualifying disposition, imagine the fair market value on the grant date was $50, the purchase date value was $60, and the employee paid $42.50. If the employee sells the stock for $75 before meeting the holding period requirements, the ordinary income is $17.50 per share ($60 purchase date value – $42.50 purchase price). The subsequent capital gain is $15 ($75 sale price – $60 purchase date value), which will be short-term or long-term depending on if the stock was held for more than one year.

Tax Reporting Requirements

After the end of a year in which you purchased stock through an ESPP, your employer is required to send you Form 3922, “Transfer of Stock Acquired Through an Employee Stock Purchase Plan.” This form is informational and provides details needed for your tax return, such as the grant date, purchase date, the fair market value of the stock on both dates, and the price you paid. You use its data to calculate your tax liability but do not file this form with your return.

When you sell the stock, the portion of your gain classified as ordinary income is considered compensation. Your employer will include this amount in the wages reported in Box 1 of your Form W-2 for the year of the sale. This ensures that the income is subject to the appropriate income tax withholding.

The capital gain or loss portion of the sale must be reported on Form 8949, “Sales and Other Dispositions of Capital Assets.” You will use information from Form 3922 and your brokerage statement to fill out this form, detailing the acquisition date, sale date, sale price, and cost basis. It is important to correctly adjust the cost basis reported by your broker to account for the ordinary income component, which prevents that portion of the gain from being taxed twice. The totals from Form 8949 are then carried over to Schedule D.