Let’s start with what I believe is the most important topic, avoiding double taxation on your Employee Stock Purchasing Plan (ESPP) sales. If you had the opportunity to participate in an ESPP, you know how great they can be to boost your income. If your employer offer an ESPP with 15% discount, you are essentially earning a minimum 15% of your stock purchase (barring a highly unlikely massive drop in price between purchase and settlement).

With every realized gain after a stock sale, the IRS comes collecting. You may think it would be the same process as any stock sale, where the brokerage sends you a 1099-B and you just copy the boxes over to your tax forms, but with an ESPP sale there is an additional component.

Let’s use the following as an example:
Shares Purchased: 10
FMV on Exercise (Purchase) Date: $100
Exercise Price Paid (15% discount): $85
Sell Price: $110

Your Brokerage will send you a form 3922 each year that documents the purchase price and discount. It is important you keep this for your records as we discuss further below.

The 1099-B sent to you form your brokerage will show a Cost Basis of $850 ($85×10 shares) and Proceeds of $1100 with a gain of $250, but what it won’t tell you is that the discount of $150 ($1000 - $850) is always taxed as ordinary income and will show up on your W-2 as well. You may or may not see it as a qualified or disqualified disposition on your W-2 depending on the how your employer’s payroll software works. If you were to just copy the numbers on the W-2 and 1099-B into your tax software without adjustments, the $150 discount will be taxed as ordinary income and a gain from a stock sale, resulting in double taxation.

To avoid this, we need to adjust the cost basis recorded on 1099-B to reflect the FMV on Exercise Date as reported on the 3922 received earlier. Remember that the 3922 is sent to you on the year of purchase, so if you’ve held the stock since 2010, you will need to find those records from 2010!

If this seems confusing, that’s because it is! Feel free to reach out if you have any questions.

Your shares are considered qualified 2 years after the date of the option is granted and 1 year after the date of exercise (purchase). ESPP options are typically granted every two years, or sooner if the ESPP grant price changes.

There’s a misconception that if you sell your ESPP shares after holding it until they become a qualified disposition, all the gains will be taxed as long-term capital gains, which is a lower tax rate than ordinary income. But in reality, the discount portion of ESPP purchases will always be taxed as ordinary income. The discount portion will show up on your W-2, although they will be not subject to FICA tax. Even when selling shares from a former employer, they will still send a W-2 for the sale. Additional gains are taxed as capital gains.

The only time there is a difference is in the event of a loss. For disqualified dispositions, the full discount is taxed and ordinary income and the loss as a capital loss. For qualified dispositions, the ordinary income minus the loss is taxed as ordinary income only, with any loss beyond the income reported as a capital loss.

Let me know what you think of this newsletter! I’d love to get your feedback and I’m very much looking forward to working with you as tax season approaches.

Happy Holidays from Capital Compass Tax and Finance!

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