When Is an Employee Stock Purchase Plan Taxed?

An Employee Stock Purchase Plan (ESPP) is a benefit offered by employers that allows employees to buy company stock, often at a discounted price. Employees typically contribute to the plan through payroll deductions over a set period, accumulating funds for stock purchases. While an ESPP can be a valuable opportunity to acquire company shares, understanding the tax implications is important. The way income from an ESPP is taxed depends on when the shares are ultimately sold.

Taxation at Share Purchase

When shares are acquired through an ESPP, employees typically receive a discount on the stock’s fair market value (FMV) on the purchase date. This discount, which can be up to 15% for qualified plans, is considered compensation. For qualified plans, this compensation is not immediately taxable; the tax event related to this discount occurs when the shares are sold.

Some ESPP plans may include a “lookback period.” A lookback provision means the purchase price is based on the lower of the stock’s FMV at the beginning of the offering period or at the end of the offering period (the purchase date). This feature allows the employee to benefit from any stock price increase during the offering period. The cost basis of the shares is their purchase price plus any ordinary income recognized from the discount. This adjusted cost basis is important for calculating future capital gains or losses.

Taxation at Share Sale

The primary tax events for ESPP shares occur when they are sold. The tax treatment depends on whether the sale is classified as a “qualified disposition” or a “disqualified disposition.” This classification hinges on specific holding period requirements from the Internal Revenue Service.

A qualified disposition occurs when the shares are held for at least two years from the offering date (the start of the plan’s period) and at least one year from the purchase date (when the shares were acquired). In a qualified disposition, the portion of the gain taxed as ordinary income is the lesser of the actual discount received or the discount calculated based on the stock’s fair market value at the offering date. Any additional gain beyond this ordinary income portion is then taxed as a long-term capital gain. Long-term capital gains receive more favorable tax rates than ordinary income.

For example, if shares were offered at $50, purchased at $42.50 (a 15% discount), and sold for $70, with the offer date being two years and six months prior to sale, and the purchase date being one year and three months prior to sale. The ordinary income recognized would be $7.50 per share (the lesser of the actual discount or 15% of the $50 offering date FMV). The remaining gain of $20 per share ($70 sale price – $42.50 purchase price – $7.50 ordinary income) would be taxed as a long-term capital gain.

Conversely, a disqualified disposition occurs if the holding period requirements for a qualified disposition are not met. This means the shares are sold either less than two years from the offering date, or less than one year from the purchase date, or both. In a disqualified disposition, the entire discount received at the time of purchase is taxed as ordinary income. This discount is the difference between the stock’s fair market value on the purchase date and the discounted price paid by the employee.

Any additional gain or loss beyond this ordinary income component is treated as a capital gain or loss, which can be either short-term or long-term depending on how long the shares were held from the purchase date to the sale date. If the shares were held for one year or less from the purchase date, any capital gain would be short-term and taxed at ordinary income rates. If held for more than one year from the purchase date, any capital gain would be long-term and taxed at the more favorable capital gains rates. For instance, if shares were purchased at $42.50 when the FMV was $50, and then sold for $60 after eight months, the ordinary income would be $7.50 per share ($50 FMV at purchase – $42.50 purchase price). The remaining gain of $10 per share ($60 sale price – $50 FMV at purchase) would be a short-term capital gain.

Adjust the cost basis of the shares to avoid double taxation on income already reported as ordinary income. The adjusted cost basis for capital gains calculations should include the original purchase price plus the amount of the discount recognized as ordinary income.

Reporting ESPP Tax Events

Employers issue Form 3922, “Transfer of Stock Acquired Through an Employee Stock Purchase Plan Under Section 423.” This form provides details about the stock purchase, such as the purchase price, the fair market value of the stock on the purchase date, and the number of shares acquired. Form 3922 is for informational purposes and helps determine the cost basis and calculate taxable gains or losses when shares are sold.

The ordinary income portion of an ESPP sale is typically included in Box 1 of your Form W-2, “Wage and Tax Statement,” issued by your employer. This income is taxed as regular wages and is subject to federal income tax withholding. Social Security and Medicare taxes do not apply to ESPP discounts.

When ESPP shares are sold, the brokerage firm handling the transaction will issue Form 1099-B, “Proceeds From Broker and Barter Exchange Transactions.” This form reports the gross proceeds from the sale and often includes a cost basis. The cost basis reported on Form 1099-B may not account for the ordinary income portion already included on your W-2. Adjust this cost basis to include the ordinary income amount to prevent double taxation.

Capital gains and losses from ESPP sales are reported on Form 8949, “Sales and Other Dispositions of Capital Assets,” and summarized on Schedule D, “Capital Gains and Losses.” When filling out Form 8949, use the information from your Form 1099-B, but adjust the cost basis in Column (e) to reflect the ordinary income already reported on your W-2. Maintain thorough records, including your ESPP statements, Form 3922, and all brokerage statements, for accurate tax filing.