Taxation of Qualified and Non-Qualified ESPPs

Employee stock purchase plans are a popular benefit offered by public companies that allow employees to purchase company stock at a discount. The taxation of ESPPs is more complicated than the regular buying and selling of stock because of a combination of ordinary income and capital gains taxes, the type of plan your company offers, how long you hold the shares before selling, and whether there’s a capital gain or a loss.

There are three important dates to keep in mind: the first day of the offering period, the purchase date, and the sale date. The first day of the offering period is also known as the grant date, and is different from when you actually sign up or enroll in the plan. The purchase date, also known as the exercise date, is the day shares are purchased by the plan, and not when payroll deductions are taken out of your paycheck.

This exploration into ESPP taxation assumes you have a basic understanding of ESPPs, so a thorough explanation of the core features of ESPPs is outside the scope of this article. Hopefully, this primer will give you a clear understanding of how your ESPP shares might be taxed.

Qualified vs. Non-Qualified ESPPs

An ESPP can either be a qualified (Section 423) or non-qualified plan, and the type of plan you’re able to participate in will typically be completely out of your control. For tax purposes, it’s important to know whether your plan is qualified or non-qualified.

Non-qualified ESPPs are taxed at two points in time: when the shares are purchased and when the shares are sold. The taxation of non-qualified ESPPs is similar to the taxation of NSOs: taxed as ordinary income when you buy the shares and a capital gain or loss when the shares are sold. Federal income, Social Security, and Medicare tax withholding is mandatory for the ordinary income portion.

Qualified ESPPs are more complicated, but the main difference compared to non-qualified plans is that the ordinary income component is deferred until the shares are sold. Federal withholding isn’t required, but some states may have a state withholding requirement for qualified ESPPs.

Taxation of Non-Qualified ESPPs

If your company offers a non-qualified ESPP, your tax situation is fairly straightforward. Ordinary income is recognized on the purchase date, and capital gains or losses are recognized when you sell.

The reference price for ordinary income purposes and the price that sets the capital gain basis is the price on the purchase date.

Taxation of Qualified ESPPs

There are two classifications of sales for qualified ESPPs: qualifying and non-qualifying dispositions. To be eligible for a qualifying disposition, you can only sell your shares after more than two years have passed since the grant date (start of the offering period) and you’ve held the shares for more than one year. This is also known as the “statutory holding period”, but I’ll call it the “two-year/one-year” requirement.

Any sale that fails to meet the two-year/one-year requirement is a disqualifying disposition and has different tax consequences.

Whether the disposition is qualifying or disqualifying, the ordinary income component for qualified ESPPs is deferred until sale. Capital gains or losses are also recognized when you sell. The reference price for ordinary income purposes and the price that sets the capital gain basis is different if the sale is a qualifying vs. a disqualifying disposition. 

Qualified ESPPs become much more complicated when dealing with rising vs. falling stock prices and the differences in how qualifying and disqualifying dispositions are taxed - not to mention how risk and financial objectives play a role in the decision-making. Since the purpose of this article is to provide clarity on the basics of ESPP taxation, we’ll leave those complexities to a future article.

Qualifying Disposition

In a qualifying disposition, the reference price for ordinary income purposes and the price that sets the capital gain basis is the price at the start of the offering period. Ordinary income and capital gains or losses are both recognized at sale - no taxes are owed when the shares are purchased.

However, there is a secondary reference price that comes into play in the event of a capital loss. If the “actual gain” is less than the purchase price discount (calculated at the start of the offering period), ordinary income is limited to the actual gain.

Disqualifying Disposition

In a disqualifying disposition, the reference price is the price on the purchase date. Ordinary income and capital gains or losses are also recognized at sale, with no taxes owed when the shares are purchased.

An Example to Illustrate Differences in Taxation:

Now that you know the basics of how different ESPPs are taxed, let’s take a look at an example. Your plan features a lookback provision that determines the purchase price as either the market price at the start of the offering period or the price on the purchase date, whichever is lower. The purchase price is also discounted by 15%.

The price at the start of the offering period is $20, the price on the purchase date is $30, and the sale price is $50. Because of the lookback provision, the purchase price is $20. After the 15% discount is applied, the price you actually pay (the discounted purchase price) is $17 per share.

Assume your ordinary income tax rate is 40% and your long-term capital gains tax rate is 20%.

Non-Qualified Example

On the Purchase Date

When the ESPP shares are purchased, the difference between the price on the purchase date and the discounted purchase price is taxable as ordinary income, with tax withholding requirements as well.

The price on the purchase date is $30 and the discounted purchase price is $17, so $13 is taxable as ordinary income on the purchase date. Your cost basis for capital gains purposes is $30.

On the Sale Date

When you sell the shares, the sale price ($50) minus the cost basis ($30) is taxable as capital gains: $20. This gain can be either short-term or long-term depending on the holding period.

Total Taxes

You’ll owe $5.20 in ordinary income tax on the purchase date ($13 times 40% ordinary income tax rate) and either $8 in short-term capital gains or $4 in long-term capital gains when you sell ($20 times 40% short-term or 20% long-term tax rate).

For a short-term sale, you’ll owe a total of $13.20 in taxes. For a long-term sale, it will be $9.20 instead.

Qualifying Disposition of a Qualified ESPP Example

On the Purchase Date

There’s no taxable event when shares are purchased as part of a qualified ESPP.

On the Sale Date

The ordinary income component of a qualifying disposition is the lesser of the actual gain or the discounted purchase price calculated as of the grant date (the first day of the offering period).

In this case, the latter is the smaller amount: a 15% discount off of the $20 price on the grant date. Therefore, $3 is taxable as ordinary income, and your cost basis for capital gains purposes is $20. For reference, the “actual gain” is the $50 sale price minus your actual purchase price of $17, or $33.

The sale price ($50) minus the cost basis ($20), or $30, is always a long-term capital gain for a qualifying disposition because of the holding period requirement.

Total Taxes

You’ll owe $1.20 in ordinary income tax ($3 times 40% ordinary income tax rate) and $6 in long-term capital gains ($30 times 20% long-term tax rate). The total tax of $7.20 is incurred when you sell the shares.

Disqualifying Disposition of a Qualified ESPP Example

On the Purchase Date

There’s no taxable event when shares are purchased as part of a qualified ESPP. Even though this is a sale that disqualifies the ESPP from its “qualified” status, there’s no way to know this until the sale.

On the Sale Date

The ordinary income component of a disqualifying disposition is the difference between the price on the purchase date and the discounted purchase price.

Like a non-qualified ESPP, the ordinary income component is calculated as the $30 price on the purchase date minus the discounted purchase price of $17, or $13. Your cost basis for capital gains purposes is $30.

Also like a non-qualified ESPP, the sale price ($50) minus the cost basis ($30) is taxable as capital gains: $20. This gain can be either short-term or long-term depending on the holding period.

Total Taxes

You’ll owe $5.20 in ordinary income tax ($13 times 40% ordinary income tax rate) and either $8 in short-term capital gains or $4 in long-term capital gains ($20 times 40% short-term or 20% long-term tax rate), both incurred when you sell the shares.

For a short-term sale, you’ll owe a total of $13.20 in taxes. For a long-term sale, it will be $9.20 instead.

A disqualifying disposition that meets long-term capital gain requirements happens when the shares are held for longer than one year, but the sale is less than two years after the grant date.

Summarized Tax Table

As a reminder of the example we’ve been working with: the price at the start of the offering period is $20, the price on the purchase date is $30, and the sale price is $50. The purchase price is $20 due to the lookback, and with the 15% discount applied, the price you actually pay is $17 per share. Your ordinary income tax rate is 40% and your long-term capital gains tax rate is 20%.

By Date Taxes are Owed

By Type of IncomE

When your company’s stock is rising and the price at the start of the offering period is less than the price on the purchase date which is less than your sale price, qualifying dispositions will result in the best tax treatment. However, this is only necessarily true in this type of rising market. In reality, volatility exists and timing might result in a higher price on the offering date compared to the price on the purchase date, an overall capital loss, or a combination of the two.

The tax benefit of making a qualifying disposition also ignores the additional risk incurred by needing to hold the shares until the two-year/one-year requirement is met. Keep that in mind when deciding when to sell.

Another Scenario for Qualified ESPPs

What if, in the example above, the price at the start of the offering period is $30 and falls to $20 on the purchase date before rocketing to $50 at sale?

Strangely enough, because of the different ordinary income/cost basis reference prices for qualifying and disqualifying dispositions, a disqualifying disposition with long-term capital gains (holding period longer than one year, but selling within two years of the grant date) ends up being slightly better than a qualifying disposition.

Ordinary income for the qualifying disposition is based on the $30 price at the start of the offering period. Even though your actual purchase price is $17 (a 15% discount off of $20), your ordinary income component is 15% off of $30, or $4.50. This might not make any sense, but this is how qualifying dispositions of qualified ESPPs are taxed.

Ordinary income for the disqualifying disposition is based on the $20 price on the purchase date and the $17 discounted purchase price. With capital gains taxes accounted for, flipping the offering and purchase date prices results in this:

This is just one example where a qualifying disposition isn’t necessarily better than a disqualifying disposition. Countless variations of price can occur, which may result in unexpected tax consequences. Other situations, like selling ESPP shares at a loss, open up a new can of worms and will be explored in a future article.

Final Summary (TL;DR)

If your company offers a non-qualified ESPP, your tax situation is pretty straightforward. Ordinary income is recognized at purchase, and capital gains or losses are recognized at sale. The reference price for ordinary income purposes and the price that sets the capital gain basis is the price on the purchase date.

Qualified ESPPs have the ordinary income component deferred until sale but have additional tax complexities as well. Qualified ESPPs become much more complicated when dealing with rising vs. falling stock prices and the differences in how qualifying and disqualifying dispositions are taxed - not to mention how risk and financial objectives play a role in the decision-making.

In a qualifying disposition, the reference price for ordinary income purposes and the price that sets the capital gain basis is the price at the start of the offering period. In a disqualifying disposition, the reference price is the price on the purchase date.

Qualifying dispositions don’t necessarily result in a better tax situation compared to disqualifying dispositions, and selling at a loss introduces a new set of considerations.

Whether your ESPP is qualified or non-qualified, it’s important that your goals and risk tolerance lead the decision of when to sell the shares. Don’t let the natural desire to pay less taxes lead you to worse decision-making. And if you’d like any guidance about how your should approach your ESPP decision-making, I’m happy to help! Just send me an email or schedule a time to talk.