By Bill Gallagher, CFP®, MPAS®

With more and more companies offering equity compensation packages to their employees, it is important for those receiving these benefits to understand the features of these different types of compensation. In my previous articles we discussed restricted stock awards (RSA), restricted stock units (RSU), and stock options. This article will focus on employee stock purchase plans. 

An employee stock purchase plan provides a way for an employee to purchase shares of their company’s stock through payroll deduction. Not only is this a convenient way for an employee to purchase stock but the plan may allow the employee to purchase stock at a discount, which is not available for purchases made through the stock market. While the IRS has set a cap on the dollar amount ($25,000) of stock that an employee can purchase during the course of the year it is still a great way to become a shareholder in your company. Before we take a closer look at the mechanics and taxation of ESPPs, let’s first review the terminology associated with these types of plans.    

• Enrollment period (or grant date) – the period during which the employee can contribute to the ESPP via salary/bonus deferrals. 
• Purchase date – the date in which the company purchases the shares on their behalf. 
• Lookback period – if there is a lookback period then the company will purchase the shares either based on the value at the end of the enrollment period or at the end of the enrollment period, whichever is lower. 

There are two types of employee stock purchase plans (1) non-qualified ESPP and (2) qualified ESPP. While the mechanics of these two plans are similar, they carry different income tax characteristics. In the non-qualified ESPP space, if an employee purchases the shares at full price (no discount), then she will not have to report income at the time of purchase. Upon sale, she will need to report the profit or loss as a capital gain or loss. 

• Example: An employee is participating in her company’s non-qualified ESPP. Over the past three months she has contributed a total of $5,000 to her ESPP. On July 1, 2021 (the purchase date) the market value of the stock is $50 per share. Therefore, the company purchases 100 shares of stock on her behalf. Since the employee paid for the full value of the shares, she will not have to report compensation income upon purchase. If she sells the shares on July 2, 2022, or thereafter, she will report the gain or loss as a long-term gain or loss. However, if she sells the shares on or before July 1, 2022, then she will report the gain or loss as a short-term-gain or loss. 

What would happen if the employee purchased the shares at a discount? In this situation, the difference between the fair market value of the shares on the purchase date and the amount paid for the shares (after applying the discount) will be reported as compensation income and subject to income tax withholding. When the shares are ultimately sold, any profit or loss will be treated as a capital gain or loss. The good news is that the basis in the shares is equal to the amount she paid for the shares plus the amount included in her compensation. 

• Example: Continuing our example from above, instead of paying for the full value of the shares, let’s assume that she receives a 10% discount. If the current market value of the stock on the purchase date is $50 per share, then she will be able to purchase the shares for $45 (after applying the discount). Therefore, if the company purchased 100 shares on her behalf, she would report $500 ($5 discount x 100 shares) as compensation income. Her basis in the shares will equal $5,000 (the amount she paid for the stock plus the amount included as compensation income) which will be the measuring point for capital gains or losses when she decides to sell the shares. 

When we compare the taxation of non-qualified ESPPs to qualified ESPPs we see that the rules are far more complex. However, with this complexity comes the ability for employee to not have to report compensation income when she purchases the shares, even if she purchases them for at a discount. In order to take advantage of this tax benefit, the employee must meet both of the following special holding periods: 

• The stock must be held for one year after the first date of the offering period, and 
• The stock must be held for more than two years after the employee receives, or purchases, the stock. 

If the employee sells her shares before the special holding period is met (early disposition), she must report compensation income equal to the difference between the purchase price and the price at the end of the offering period.  

• Example: The fair market value of the stock $20 per share at the beginning of a three-month offering period and $21 at the end of that period, at which time the stock is purchased. The employee stock purchase plan offers a 15% discount from the lower of those values (lookback period), so the employee purchases the stock at $17 per share. If she sells the stock before satisfying the special holding period, she will report $4 per share of compensation income, which is the difference between the $21 value and the $17 purchase price. 

It is important to understand that the employee must report compensation income even if she doesn’t have a profit when she ultimately sells the stock. 

• Example: As we saw above the employee had to report compensation income of $4 per share. She paid $17 for the stock, and as we know, the $4 per share of compensation income is added to her basis. Therefore, her basis in the shares will equal $21 (the amount she paid for the shares plus the amount included as compensation). If she sold the stock for $15 per share, she would report a capital loss of $6 per share but still need to report the $4 per share of compensation income. However, if she sells the stock for a profit, she will report the profit as a capital gain. 

If you are reaching for the Advil at this point, you are not alone! But hang-in there, we are almost at the finish line. 

What happens when the employee satisfies the special holding period? In this situation the employee may have to report compensation income, even if the sale takes place after the special holding period has been satisfied. The good news is that if the employee does not have to report compensation income if she sells the stock for a loss. This is different than we saw above. However, if the stock is sold at a profit, then she will have to report compensation income. The amount of compensation income is the lesser of the amount of her profit or the difference between the market value of the stock at the beginning of the offering period and the amount you paid for the stock. 

• Example: Continuing the example from above, the value of the stock at the beginning of the offering period is $20 per share and she purchased the shares for $17 per share (after taking into account the discount) at the end of the offering period when the stock is worth $21 per share. If she sells the stock at $25 per share, after meeting the special holding period, she will have to report compensation income in the amount of $3 per share (the difference between $20 and $17). This is less than the $4 per share we saw above. In addition to the compensation income, she will incur a capital gain of $5 per share (the difference between her basis of $20 per share and the sales price of $25 per share). 

With equity compensation becoming more popular, it is important for employees to not only understand the form of equity they receive but to also understand the tax consequences. In addition, it is important to incorporate the equity you receive in your overall financial plan. How does the equity impact your long-term goals and objectives? How does the equity fit into your risk tolerance and other investments?  What is my tax situation? Does it make sense to participate in my company’s employee stock purchase plan? Should I sell the shares before meeting the special holding period? If you find yourself in the fortunate position where your company is providing you with equity compensation, then I would strongly recommend you reach out to your financial planner so that you can get a comprehensive look at how the equity compensation impacts your financial situation.