Selling shares, or even giving them away, can trigger tax liability.
The benefit you receive under an employee stock purchase plan is a form of compensation. You don’t have to report compensation income when you purchase the shares, but you may have to do so when you dispose of the shares. That’s true even if you make a gift of the shares. In fact, compensation income may appear on your final tax return if you die holding the shares.
The amount of compensation income you report depends on whether your disposition is a disqualifying disposition. In general, this is any disposition (sale or gift) unless both of the following are true:
- It is more than a year after the purchase of the shares, and
- It is more than two years after the grant date.
For this purpose, the grant date is normally the beginning of the offering period. Tax regulations issued in 2009 specify that in some situations the end of the offering period (when you purchase the shares) will be considered the grant date. Your company should inform you if this is the case.
Note that holding the shares a year and a day won’t necessarily be long enough to avoid a disqualifying disposition even if the grant date is the beginning of the offering period.
Example: Your company’s ESPP has a six-month offering period, with the grant date being the beginning of that period. You buy shares and, 13 months later, you sell them. This is a disqualifying disposition, even though you held the shares more than a year, because you didn’t hold the shares until more than two years after the grant date. To avoid a disqualifying disposition in this situation, you would have to hold the shares more than 18 months.
If you die holding the shares, your death is treated as a disposition but not a disqualifying disposition, even if you die before satisfying the special holding period.
When you hold the shares long enough to avoid a disqualifying disposition, you don’t necessarily avoid having to report compensation income when you sell the shares. This is a major difference between ESPP shares and stock you receive from incentive stock options. You may reduce the amount of compensation income by holding shares longer, but you don’t necessarily eliminate it.
In fact, because of the quirky way these rules work, it’s even possible to have a situation where you pay less tax on a disqualifying disposition than you would if you held the shares longer and made a qualifying sale at the same price. The facts that present that situation are a little unusual but not entirely bizarre: the stock has to go down during the offering period and then go up again before you sell the shares. You can’t always assume it’s a good idea to continue holding the shares until you satisfy the holding period.
There’s one situation where it can be very important to satisfy the holding period, however. If you have a sizable benefit at the time you purchase the shares but the stock price declines sharply afterward, you can end up paying tax on phantom income if you make a disqualifying disposition.
Example: You decide to contribute $10,000 during an offering period and that turns out to be a good choice: the stock price rises dramatically, and because of a lookback provision you’re able to buy $25,000 worth of stock, giving you a $15,000 benefit. You hold onto the stock only to see the price fall just as dramatically, leaving you with shares worth just $8,000.
In this situation, a disqualifying sale will require you to report $15,000 of compensation income. You’ll also have a $17,000 capital loss on the sale, but because of the capital loss limitation you can deduct only $3,000. Overall, you have an out-of-pocket loss of $2,000 but you had to pay tax on $12,000 of phantom income ($15,000 of compensation income minus $3,000 of capital loss). By contrast, if you hold the shares long enough to avoid a disqualifying disposition, you would report no compensation income in this situation, just a capital loss of $2,000.
Details on the tax calculation for disqualifying dispositions are provided here, and details on the tax calculation for qualifying dispositions are provided here.