As a follow up from last week’s blog, Overview of Employee Stock Purchase Plans (ESPPs), I would like to discuss the taxation of ESPPs.
Under most ESPPs, an employee that participates in the plan makes their purchases of company stock through payroll deductions. All of the purchases are made with after tax dollars. As mentioned last week, if the plan is a qualified 423 Plan ESPP, the employee can receive special tax treatment on the purchased shares.
Because the shares are purchased with pre-tax, at the time of purchase, the employee does not report any income. The tax occurs once the shares are sold. The challenge is determining whether the shares sold are considered a qualifying sale. A qualifying sale occurs when a disqualifying disposition is avoided.
How does an employee avoid a disqualifying disposition? Simply put, the employee must meet two (2) requirements.
1. No disposition occurs within two years from the grant date, i.e., the beginning of the offering period.
2. No disposition occurs within one year after the shares are transferred to the employee.
If the employee meets this criteria, they can avoid a qualifying sale when the amount of income they would report would be the lesser of the following two amounts:
• The difference between the fair market value of the shares on the date of disposition and the amount paid to acquire the shares.
• The bargain element at the beginning of the offering period.
What is the Bargain Element? The bargain element is the difference between the fair market value of the stock at the beginning of the offering period and the price that would have been paid for the stock if it were purchased at the beginning of the offering period, versus over a period of time. This usually is the 15% discount the company offers.
Dan’s Moral: Understanding the holding period needed to avoid a disqualifying disposition could save a lot in taxes.
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