The ESPP Tax HACK You’ll REGRET
Welcome to the ultimate guide on ESPP taxation for beginners. I’m walking through the how ESPPs are taxed, and how to avoid the dumb mistakes that cause you to pay more tax. I’m covering everything you need to know including examples, and most importantly, the common ESPP tax hack that can actually break your taxes.
ESPPs Taxation
This is the world's easiest ESPP tax graph that will take you from beginner to smarter than most CPAs on ESPPs in just a few minutes. This graph shows all the tax outcomes from gains to losses across all holding periods.
ST / LT: Short-Term / Long-Term
CG / CL: Capital Gain / Capital Loss
How are ESPPs taxed? There are no taxes until you sell the stock with qualified ESPPs. This is what I love about Employer Stock Purchase Plans. Because you can choose when to sell, you’re essentially choosing when to trigger taxes, which gives you a lot of flexibility and opportunities to reduce your tax bill. Let’s address the taxation of ESPPs chronologically.
Disqualifying Disposition — Section 423(b) of the Code
Date of Disposition
Put simply, there are only 2 possible tax outcomes when it comes to ESPPs: ordinary income (w2 income), or capital gains/losses. Deciding how much is taxed at ordinary income rates versus capital rates is where the complexity lies.
In disqualifying disposition, the w2 portion of your tax is determined by looking at the purchase date—the date where your company actually uses your contributions to buy company stock. Any difference between the purchase price and the actual fair market value is included as ordinary w2 income when you sell. So while there are no taxes due on the purchase date for qualified ESPPs, it’s still important for calculating taxes. Fortunately, your ordinary w2 income doesn’t include FICA tax (or social security and Medicare). This is one of the benefits of a qualified ESPP (or Section 423 plans). Unfortunately, the ordinary w2 income tax isn’t always this easy to calculate. We’ll address the other calculation in a minute.
Example 1: If you sell for $20, your cost basis (what you paid for the shares) would be $8.50. This amount isn’t taxed. You would have $6.50 worth of ordinary income reported on your W2, and $5 of short term capital gains to report.
Taxation of ESPPs when sold for a short-term capital gain in disqualifying disposition
But first, just know that for Non-Qualified ESPPs (which are less common), any spread between the purchase price and the fair market value is taxed on the purchase date as ordinary w2 income, subject to withholdings and Social Security tax.
We’ve covered the ordinary, w2 income portion, but the last portion of your taxes due upon sale is capital gains or losses. Anything sold within 1 year of the purchase date will be taxed at short term capital gains (STCG) rates. But, what if you sell for a loss?
Example 2: Let’s say you sell your shares for $8. Your cost basis is still $8.50 because that’s what you paid for the shares. You have a short-term capital loss of $7. The scary part is you still owe $6.50 in ordinary w2 income.
Why is this? It’s because the IRS still views you as receiving a benefit from either a discount or a lookback (or both) on the purchase date. It seems kind of silly, but, yes, you may still owe taxes even though you didn’t technically receive the benefit. The nice thing about paying this tax is that it becomes part of your tax basis—meaning, you can now write that loss off against other gains…specifically, short term capital gains and potentially ordinary income on schedule D (form 8949). So in addition to your ordinary income of $6.50, you also get a short-term capital loss of $7 to offset current and future gains or income. But, should you sell for a loss? I’ve got another article and video addressing these ESPP considerations. If there was no lookback or discount, you’d have no ordinary income to report, but just a short-term capital loss of $7.
What if you sell after holding longer than 1 year? Well, for the most part, the rules we just reviewed are the same, but instead of short-term gains and losses, items will have long-term gains and losses. Here are 2 quick examples:
Long-term Capital Loss (LTCL): If you sold for $8, you would have paid $8.50 for the stock, you’d owe $6.50 in ordinary w2 income and have a long-term capital loss of $7. And if there was no lookback or discount in your ESPP, then it’d all be a long-term capital loss of $7.
Long-term Capital Gain (LTCG): On the other hand, if you sold for $20, your cost basis would still be $8.50, you’d owe $6.50 in ordinary w2 income, and $5 in long-term capital gains. Without a lookback or discount, you’d owe $5 in long-term capital gains.
Qualifying Disposition — Section 423(c) of the Code
Up to this point, there hasn’t really been any tax benefits besides the ability of choosing when to sell. But this is where the whole benefit behind qualified ESPPS (or section 423 plans) actually begins. Ironically, this is also the place where the tax break—can break your taxes. This is hilarious because the whole purpose behind qualifying disposition is to be a tax benefit. So did congress achieve its objective by creating this tax law? Not exactly. You can actually pay more in taxes through the benefit of qualifying disposition (which is only available in qualified ESPPs). But first, you need to understand the basics.
“You can actually pay more in taxes through the benefit of qualifying disposition.”
If you hold your shares one year from the purchase date and two years from the first day of the offering period, then your taxes switch from short-term capital gains rates to the advantageous long-term capital gains rates. Except, there’s still one small portion that may be taxed at ordinary rates.
Unlike disqualifying disposition where we looked at the purchase date to determine the w2 income tax...In qualifying disposition, we’re going to look at two dates to determine the w2 income tax:
The first day of the offering period and
The date of sale.
The amount of w2 income tax due is calculated by comparing the lower number between these two dates...the discount on the first day of the offering period, or the actual gain (the difference between the purchase price and the fair market value), whichever is lowest. It’ll assign the lowest number to be your ordinary w2 income tax due.
We’re covering a lot, so I’ve created a FREE cheat sheet you can download below.
ESPP Tax Guide
Qualifying Disposition Trap
This is where the tax benefit can break your taxes. This is known as the qualifying disposition trap. You can know if you have this by looking at the lookback. Was the lookback unfavorable? Meaning, was the stock price on the offering date higher than the stock price on the purchase date (see below)? If yes, then it might not make sense to hold for qualifying disposition.
Because the ordinary, W2 income in qualifying disposition is determined by looking at lower of the discount on the offering date (not the purchase) and the actual gain (above the basis), the ordinary income becomes higher than it would have had you sold in disqualifying disposition. So when people think they’re getting a tax benefit, they could actually be paying more in taxes.
I would argue that taxes isn’t the most important important thing when planning your ESPPs and when to sell. I've compiled a list of ESPP tips and tricks that you can access by clicking the image below…
