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In the last post, we talked about the basics of ESPP’s, and I warned you that the tax situation warranted a post in and of itself. Well, here it is! With a few pictures, hopefully it will come clear.
Let’s start with the basic diagram below. At this level, the tax situation is rather simple: the difference between the price at which you bought the stock and the price at which you sold it is income, and thus is taxed.
Sounds simple, right? Well, the trick is how it is taxed. There are three options:
Compensation (ordinary income): Part of your ESPP income is taxed as compensation, i.e. at your normal income tax rate.
Short-term Capital Gains: If you held your shares for a year or less after you purchased them, the part of your ESPP income not taxed as compensation is taxed as short-term capital gains. Currently, that means they’re taxed at the same rate as compensation.
Long-term Capital Gains: If you held your shares for more than a year after you purchased them, the part of your ESPP income not taxed as compensation is taxed as long-term capital gains. As of September 2017, that means they’re taxed at 20%, 15% or 0%, depending on your income.
OK, that doesn’t sound so bad. So that means that all we have to do is figure out how much of the income is compensation, and we’re home free, right? Well, yes…and that’s the tricky part. There are two situations we need to go into: “disqualifying dispositions” and “qualifying dispositions”.
Disqualifying Dispositions: If you did not hold your shares for more than two years after the “grant date” (beginning of the offering window; see previous post) and more than one year after purchasing them, this is a “disqualifying disposition”. In a disqualifying disposition, the difference between the amount you paid for the shares and the amount they were worth when you bought them — in other words, your discount — is counted as compensation income. The rest — the difference between the amount the shares were worth when you bought them and the amount they were worth when you sold them — is capital gains; long-term if you held the shares for more than a year after purchasing them, short-term otherwise.
Qualifying Dispositions: If you held your shares for more than two years after the grant date and more than one year after purchasing them, this is a “qualifying disposition”. In a qualifying disposition, your compensation income is equal to the difference between what you paid for the shares and what you sold them for or the discount (difference between what you would have paid for the shares and what they were worth) on the grant date, whichever is lower. The rest is long-term capital gains since, by definition, you held the shares for longer than one year. So an ideal situation would look like this:
That’s good — more of your income is taxed at the (lower) long-term capital gains rate. But here’s a bizarre twist: in the following situation, where you would actually pay more in taxes for a qualifying disposition than for a disqualifying disposition!
Check out what happens in a qualifying disposition when the stock price goes down and then back up:
The part that's compensation income is equal to the bargain element at grant -- $15, in this case. Now, take a look at a disqualifying disposition:
In the case of a disqualifying disposition, the compensation income is equal to the difference between the purchase date FMV and your purchase price. This means that more of the income is taxed as compensation in the case of a qualifying disposition, which means that in this case you might actually pay less in taxes for a disqualifying disposition than you would if you waited until it were qualifying!
And that’s how ESPP taxes work. You’ll remember that forever, right? Well, if perchance you think something more important might displace its spot in your memory, feel free to bookmark this article and refer back to it later. (And yes, I refer to this article myself. ;) )
So…now what? This theoretical knowledge is all well and good, but what we should actually do with our ESPP shares? Do we participate in our company’s ESPP, or no? Do we sell some or all of the shares immediately? How long should we hold on to them? I’ll discuss all of these questions in the final post in this series.