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ESPP Disqualifying Disposition

Aaron Szager, CFP®, Senior Wealth Advisor explains the Employee Stock Purchase Plan (ESPP). If you work for a publicly traded company, chances are that your company allows you to participate.

What is an ESPP? From a conceptual standpoint, an ESPP is relatively simple and straightforward. It is an elective benefit where employees can purchase company stock at a discount—typically 10 to 15 percent—through payroll deductions.

This benefit is magnified when there is a look-back period, during which the discount is based on the lowest stock price between the beginning of the offering and the purchase date. The IRS caps the employee’s contributions to $25,000; however, this amount is often lower depending upon restrictions by the company.

Here is a list of 5 common mistakes made by employees with ESPP plans:

Mistake 1:  Not taking advantage of the benefit

If your strategy is to sell your ESPP shares immediately after purchase, you have every reason to take full advantage of the benefit. This is, of course, if you can afford the payroll deductions from a cash flow standpoint. When the shares are purchased, you receive an immediate “bonus” of the difference between the fair market value of the stock and the discounted purchase price. The benefit has the potential to be much more if the stock has appreciated in value and your company has a look-back period.

Mistake 2:  Out of sight, out of mind

Many employees do not have an exit strategy when it comes to ESPP shares. This can become an issue from both a concentrated position and taxation standpoint. I have witnessed many employees ignore their ESPP shares and, over time, it can become a significant percentage of their net worth. The adage, “What goes up must come down,” can very well apply to company stocks, and divesting from a concentrated position may be a suitable strategy to mitigate risk. This is especially true if you have the potential to have more of the stock through Restricted Stock Units (RSUs) or stock options. 

Mistake 3:  Understand the Gifting Rules

Typically, if you own low basis stock, you may gift the current market value of the stock to a charitable organization and take a tax deduction for the full amount on Schedule A of your tax return. In the case of ESPP, no matter if you gift to your children or a charity, the discount component will be added to your taxable income in the year of the gift. The benefit is reduced if the gift is made during the “disqualifying disposition” period.

Mistake 4:  Not Understanding Taxation

There is never a tax implication when you purchase ESPP shares. However, when you sell shares, there is always a compensation component, and a capital gain (or loss) component. The capital gains can be considered either long-term or short-term depending upon whether it is a qualifying or disqualifying disposition. As explained below;

  • Short-term gains are taxed at the same rate as ordinary income.
  • Long-term gains are taxed at a lower, more favorable rate. 
  • Qualifying Dispositions– a sale is considered a “qualifying disposition” if the shares are held two years from offering date and one year from the purchase date;
  • Disqualifying Disposition–Shares are sold less than two years from offering date and one year from purchase date.

Mistake 5:  Keep records

Many companies who custody the ESPP shares do not report accurate tax information. If you are employed by the company and make a sale, the compensation portion is reported through your paystub. The basis is also often reported either as $0 or the discounted purchase price. If you pay ordinary income tax on 15 percent discount and capital gains tax on the same discount, your tithing to the IRS and state is more than it should be; in other words, you are paying tax twice. This becomes more of an issue if you leave the company and hold on to the shares. If the compensation component does not run through payroll, you are required to manually enter the correct information on your return.

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