Last week I sold 67 shares of Halliburton (HAL) that I had purchased through the employee stock purchase plan (ESPP). While purchasing shares through an ESPP can be risky due to having both investments and your income tied to the health and growth of your employer, I feel that it's a risk worth taking if you are given a discount on the purchase price. Most plans do allow for a discount and luckily mine is at the maximum of 15%. The discount is just too much for me to justify passing it up. Plus my plan has no stipulation on when I can sell the shares, although your mileage may vary.
I had an idea of how the taxes were handled with purchasing shares through an ESPP but finally hammered down and figured it out since this is now something I need to account for with the recent sale and most like 200 more shares being sold later this month through executed call options.
An ESPP plan allows you to purchase shares of stock in your employer through post-tax payroll withholdings. You can choose to have between 0% and 10% of your income withheld. Most plans offer discounts on the purchase between 0% and 15%. As I mentioned above, luckily mine offers a 15% discount. Typically plans have a 6 month withholding period with the grant date being the first day of the period and the purchase date being the last day.
A disposition is just another term for sale and comes as qualifying or disqualifying. A qualifying disposition is when the shares are sold 2 years after the grant date AND 1 year after the purchase date. All other sales are disqualifying dispositions.
Closing price on grant date
Closing price on purchase date
Number of shares
That's much more complicated than regular purchases in your taxable account, although there are advantages to the plan since some of the income is considered income while some is considered capital gains as well as that discount.
There's 3 possible combinations as far as tax treatment upon sale of shares purchased through an ESPP. You can have a disqualifying disposition with short-term capital gains, disqualifying disposition with long-term capital gains, and a qualifying disposition. Let's run through the calculations for each of the three combinations.
In all of the examples I'll assume a $10 commission upon sale of the stock as well as a 15% discount from the lower price between the close on the grant date and purchase date. 100 shares will have been purchased in all 3 examples. I'll also use a $25 price on the grant date, a $30 price on the purchase date, and a $50 sale price. Based on the 15% discount this gives a discounted purchase price of $21.25.
Case 1 - Disqualifying disposition with short-term capital gains
Grant date - 1/1/2011
Purchase date - 6/30/2011
Sale date - 1/20/2012
To calculate the amount considered ordinary income you subtract the discounted purchase price from the closing price on the purchase date. In this case that would be $30.00 - $21.25 = $8.75. Then multiply this by the number of shares, $8.75 x 100, giving $875 that you would need to report as income. With most plans, this amount will already be reported on your W-2; however, it won't always be so you need to double check that it's there, lest you want to meet your friends from the IRS.
The capital gain amount is calculated as your sale proceeds less your cost basis. In this case the sale proceeds would be $50 x 100 - $10 = $4,990. The cost basis is calculated from the discounted purchase price plus the amount reported as income giving $21.25 x 100 + $875 = $3,000. Therefore your short-term capital gains are calculated as $4,990 - $3,000 = $1,990.
Case 2 - Disqualifying disposition with long-term capital gains
Grant date - 6/30/2010
Purchase date - 1/1/2011
Sale date - 1/20/2012
Both the income and capital gains values are calculated the same as in case 1. The only difference being that long-term capital gains rates will apply to your gains since you owned the shares for over one year.
Case 3 - Qualifying Disposition
Grant date - 1/1/2010
Purchase date - 6/30/2010
Sale date - 1/20/2012
Since it's been more than 2 years from the grant date and more than 1 year from the purchase date this is considered a qualifying disposition. This is where another advantage from the ESPP programs can come into play since you're allowed two different calculations for your income amount and use the lesser of the two as reported income.
The first income calculation takes the gross sale proceeds less the discounted purchase price less the commission. For this example that would be $5,000 - $21.25 x 100 - $10 = $2,865.
The second income calculation is based off the actual discount received. That would be 100 x ($25 - $21.25) = $375.
You would then need to report the lesser of the two as ordinary income when you file your taxes that cover the year of the sale.
The long-term capital gain amount also must be reported. The cost basis is the actual price paide plus the amount that is considered ordinary income. This gives a cost basis of $21.25 x 100 + $375 = $2,500. The long term capital gain to be reported is $5,000 - $2,500 - $10 = $2,490.
Grant date - 7/1/2011
Purchase date - 12/30/2011
Sale date - 7/9/2013
Closing price on grant date - $51.00
Closing price on purchase date - $34.51
Discounted purchase price (85% x minimum of grant date close and purchase date close) - $29.33
Sale price - $44.56
Commission - $8.01
Since I sold the shares more than two years after the grant date and held the shares for more than one year, this is a qualifying disposition.
The income amount calculations work out to be the lesser of $1,012.17 and $346.83. My cost basis works out to $2,312.17 with sale proceeds of $2,977.51 leaving a long-term capital gain of $665.34.
The total gain will always be the same but the distribution between income and capital gains is what can make qualified dispositions especially useful. As you can see a qualified disposition is typically the best case since you are able to shift more of the total gain from ordinary income to long-term capital gains. Assuming a 25% marginal tax bracket you could save 10% in taxes from this by holding at least two years. However, don't assume that's always the case. If you're close to satisfying the holding period then it's important to run through the calculations because a disqualifying disposition might be best depending on your specific circumstances.
One quirky situation is if you suffer a loss with a disqualifying disposition. You actually end up reporting the discount still as ordinary income despite you losing money and then having a capital loss that offsets the income to arrive at your actual loss. Bummer!
The tax laws on employee stock purchase plans, much like the whole tax code, are very confusing and can lead to illogical conclusions. Until that changes all we can do is take advantage when we see the opportunity.
*I've added a spreadsheet where you can put in your own numbers and the income and capital gains amounts are calculated for you.