ESPP Taxation

ESPP taxation can be complex, especially given different types of ESPP plans (each with differing tax treatment). Here is what you need to know!

Pre-Read: Key Questions This Article Answers

How are ESPPs taxed, and why is it so complicated?
How does taxation differ if an ESPP plan is (i) qualified, vs. non-qualified?
What are the optimal tax benefits of a qualified ESPP plan, and how do I achieve them?
What is a qualifying/disqualifying disposition within an ESPP plan?

Tax Implications of ESPPs

To understand how your ESPP will be taxed, the first step is determining whether you have a Qualified or Non-Qualified ESPP. Tax treatment differs significantly between the two plan types. Reminder, ~80% of ESPP plans are Qualified, and ~20% are Non-Qualified.

(1) Qualified ESPP Taxation

With a Qualified ESPP, taxation does not occur during the enrollment period or on the purchase date, even if you receive a discount on the purchase price. Instead, taxation is deferred, and triggered when you sell the shares. The specific tax treatment differs depending on whether you have a Qualifying Disposition (QD) or Disqualifying Disposition (DD), and if you have a gain or loss upon sale.

(1A) Qualifying Disposition (of a Qualified ESPP Plan)

A qualifying disposition occurs when ESPP shares are held for at least two years after the grant date and one year after the purchase date. The taxes you trigger/will owe upon sale (if any) depends on the gain/loss you realize when you sell the shares. Note: For a qualifying disposition, any discounted purchase price due to a lookback provision is taxed as long-term capital gains.

Shares Increased in Value (Sale Price > Undiscounted Price)

The amount of discount you received on the purchase date (if any) is taxed as ordinary income
All additional gains are taxed as a long-term capital gain (including the discount, if any, from a lookback provision)

Shares Modestly Decreased in Value (Undiscounted Price > Sale Price > Discounted Price)

You will owe ordinary income tax on the difference between the sale price and your discount price (e.g. you got a 15% discount, purchasing shares for $8.50 when the price was $10.00. You sell when shares are $9.50. You will owe $1 per share of income tax ($9.50 - $8.50)
No capital gains apply

Shares Decreased in Value (Discounted Price > Sale Price)

No income taxes are due/owed
You will realize a capital loss

(1B) Disqualifying Disposition (of a Qualified ESPP Plan)

A disqualifying disposition occurs when ESPP shares are not held for at least one year after the purchase date and two years after the offering date. You will owe ordinary income tax on the discount, with the remaining profit/loss being capital gains. Note: For a disqualifying disposition, any discounted purchase price due to a lookback provision is taxed as ordinary income.

Shares Increased in Value (Sale Price > Undiscounted Price)

The amount of discount you received on the purchase date, including a discount (if any) via the lookback provision, is taxed as ordinary income
The gain on sale above the price on the purchase price is taxed as capital gains. Long-term if the sale occurred more than 1 year after the purchase date; otherwise short-term

Shares Modestly Decreased in Value (Undiscounted Price > Sale Price > Discounted Price)

The amount of discount you received on the purchase date, including a discount (if any) via the lookback provision, is taxed as ordinary income
No capital gains apply; you will realize a capital loss

Shares Decreased in Value (Discounted Price > Sale Price)

The amount of discount you received on the purchase date, including a discount (if any) via the lookback provision, is taxed as ordinary income
No capital gains apply; you will realize a capital loss

(1C) State and Payroll/FICA (of a Qualified ESPP Plan)

State income tax. Most state taxes fully conform to federal tax treatment for Qualified ESPP proceeds (i.e. what/how taxed is the same). Though some states partially conform or opt out. Individuals should check with their state's tax rules regarding ESPPs.

Payroll/FICA tax. Qualified ESPPs are statutory/qualified, and as such, are not subject to FICA (Medicare and Social Security) taxes. Also, income taxes are not withheld upfront but are still owed if/when applicable.

(2) Non-Qualified ESPP Taxation

With non-qualified ESPPs, there are no tax-deferred benefits. Taxation occurs on the share purchase date. There are no qualifying or disqualifying dispositions.

The discount upon purchase--both (1) an explicit discount, and (2) the lower price received due to the lookback provision (if any)--is taxed as ordinary income on the purchase date.
The increase/decrease in value thereafter will be a capital gain/loss. Whether that is a short-term or long-term capital gain/loss depends on if you hold the stock for more than 1 year after the purchase date.

Note: Because non-qualified ESPPs do not receive the same tax benefits as qualified plans, employees will owe state income taxes and FICA taxes on the discount. The discount is considered compensation, so employers will report it on employees’ W-2 forms and withhold applicable payroll taxes.

Unique Items and Special Situations

Employer Matches on Non-Qualified ESPPs

Non-Qualified ESPP plans provide more flexibility to employers. Some employers offer matches on employee contributions, similar to a 401(k) match. If an employer match is provided, the match amount is taxed as ordinary income to the employee. The employee will receive a W-2 for the total match amount, and will owe income taxes on that amount for the tax year in which the match was provided.

Potential for Refunded Cash

For some ESPP plans, if the stock price at the end of the offering period is lower than at the beginning of the period, employees receive a refund of a portion of the payroll deductions they contributed during that period. This is a refund, and as such is not taxable to employees (the employer simply refunds the accumulated payroll deductions).