Employee stock purchase plan taxes

In short

A friend of mine once sold his company shares the same week he got them and never thought twice about the tax. The bill surprised him in April. If your company offers an employee stock purchase plan, you have probably wondered how the tax works. Here is the plain version. Your discount on the shares is taxed as pay, and the timing of your sale decides how much of it. Selling right away is simple, and the whole discount becomes ordinary income. Holding the shares past two dates can move part of the gain into the lower long term capital gains rate. Your Form 3922 and your broker statements hold the numbers you need. Keep the cost basis straight, because that is where many people pay twice.

The whole of it

What it is

I once sat beside a neighbor who called his stock plan "free money." It is a good deal, but the free part comes with a tax form attached. You have probably seen the plan on your benefits page. You sign up, a slice of each paycheck is set aside, and on a set date the plan buys company stock for you at a discount.

The tax code treats the discount as a kind of pay. Tax rules for these plans sit in Internal Revenue Code Section 423, and the IRS explains them in Publication 525, Taxable and Nontaxable Income. Plans that follow Section 423 are called qualified plans. Some employers run plans outside those rules, and those are taxed differently, so check which one you have.

You are already doing well, and a plan like this can help you. It just asks you to keep good records.

How it works

A friend once described his plan as a savings account that buys stock. That is close. Money comes out of your pay after tax. At the end of an offering period, the plan uses it to buy shares at a price below market. The most a qualified plan may discount the price is the current figure, which the official source publishes each year. Some plans also look back to the lower of two prices. Your plan documents spell out your own terms.

Buying the shares is not a taxable event. Selling them is. When you sell, the tax depends on how long you held them, and the law sets two clocks. The first runs two years from the start of the offering period, which is the grant date. The second runs one year from the purchase date.

If you sell after both clocks have run, you have what the IRS calls a qualifying disposition. The gain is split in two parts. One part is ordinary income, taxed like your salary. It is the smaller of two figures. The first is the actual profit on the sale. The second is the discount measured at the grant date price. Anything left over is long term capital gain.

If you sell before either clock has run, you have a disqualifying disposition. The discount at purchase is ordinary income. That means the market price on the purchase date minus what you paid. Any gain or loss beyond that is capital gain or loss. It is short term if you held one year or less, and long term if you held longer.

Here is the catch for higher earners. Ordinary income is taxed at your top bracket, which may be high. Long term capital gains get a lower rate. At your income level you may also face the net investment income tax on investment gains. The IRS covers that on its page about the net investment income tax.

The numbers, and where to find yours

I know a woman who kept every plan statement in one folder, and her tax season took an afternoon. Do what she did. Three kinds of paper matter.

The first is Form 3922, Transfer of Stock Acquired Through an Employee Stock Purchase Plan. Your employer sends it after shares are bought. It shows the grant date price, the purchase date price, and what you paid. The second is your broker statement or the Form 1099 B it sends when you sell. The third is your Form W 2, which is where your employer may report pay income.

That last point trips people up. Do not assume your W 2 already counts the ordinary income from a sale. Look at the boxes and compare them with your own math. If the amount is missing or looks off, ask your payroll office. The 1099 B often shows your basis as just what you paid, so it can be too low. If you use that number as is, you may pay tax on the discount twice. IRS Publication 550, Investment Income and Expenses, explains basis and how to report these sales.

Some limits are set by law and change. The yearly cap on how much stock you can buy under a qualified plan is the current figure, which the official source publishes each year. Your top ordinary income rate is the current figure, which the official source publishes each year. The long term capital gains rate at your income level is the current figure, which the official source publishes each year. The net investment income tax rate is the current figure, which the official source publishes each year, and the income level where it starts is the current figure, which the official source publishes each year. The site fills in each figure with its source and date. Please check them against the year you sell.

A worked example

Let me tell you about a man named Daniel. He earns 240,000 dollars a year and joins his company plan. The offering period starts on January 1, when the stock trades at 40 dollars. The purchase date is six months later, on June 30, when it trades at 50 dollars. The plan gives a 15 percent discount on the lower of the two prices. The lower price is 40 dollars. So Daniel pays 40 times 0.85, which is 34 dollars a share.

He buys 100 shares. He pays 34 times 100, which is 3,400 dollars. On the purchase date those shares are worth 50 times 100, which is 5,000 dollars.

First, say Daniel sells on July 15 at 55 dollars a share. That is a disqualifying disposition. The ordinary income is the market price at purchase minus what he paid, so 50 minus 34, which is 16 dollars a share. Times 100 shares, that is 1,600 dollars. His basis is now 3,400 plus 1,600, which is 5,000 dollars. He sells for 55 times 100, which is 5,500 dollars. The short term capital gain is 5,500 minus 5,000, which is 500 dollars. Total profit is 5,500 minus 3,400, which is 2,100 dollars. Check it: 1,600 plus 500 equals 2,100. Good.

Now say Daniel holds. He waits until more than two years after January 1 and more than one year after June 30. He sells at 60 dollars a share, for 6,000 dollars. This is a qualifying disposition. His actual profit is 6,000 minus 3,400, which is 2,600 dollars. The discount at the grant date price is 40 minus 34, which is 6 dollars a share, or 600 dollars for 100 shares. The ordinary income is the smaller of 2,600 and 600. That is 600 dollars. His basis becomes 3,400 plus 600, which is 4,000 dollars. The long term gain is 6,000 minus 4,000, which is 2,000 dollars. Check: 600 plus 2,000 equals 2,600. It matches.

Notice what changed. In the first case 1,600 dollars was taxed as ordinary income. In the second, only 600 was. Daniel took on the risk of holding, though, and the price could have fallen. That is a choice for him, and this guide does not tell him which way to go. It only shows what each path costs in tax.

Where it goes wrong

I once watched a smart fellow forget a form in a drawer, and it cost him real money. The same mistakes show up again and again. Few of them come from carelessness. They come from busy lives.

The biggest is the basis error. If you accept the 1099 B basis without adding the ordinary income, you report too much gain. You pay tax on the same dollars twice. Fix it on Form 8949 when you file.

Next is a missed clock. Count the days from the grant date and the purchase date, not from the day you signed up. Selling one day early can turn a qualifying sale into a disqualifying one. That costs you.

Then there is the cash. Your paycheck deductions are after tax money. When you sell, you may owe more in April than your withholding covered. A bump in income can also push you toward the net investment income tax. Set aside money for the bill.

Last, watch concentration. Your paycheck and your savings both lean on one company. This guide does not tell you to buy or sell. It only notes that the tax is one part of the picture, and that the risk of one company is another.

Questions to answer before you leave this page

Do you know whether your plan is a qualified Section 423 plan or something else? What are the grant date and the purchase date for the shares you hold now? Have you found your Form 3922 for each purchase, and does it match your broker records? Will your sale be a qualifying or a disqualifying disposition, and have you counted both clocks? Did your W 2 already include any ordinary income from a past sale, and does your basis reflect it? How much tax might you owe in April, and where will that cash come from? Would a tax professional or the plan administrator help you check your numbers before you sell?