Disqualifying Dispositions in ESPPs

If you’ve participated in a qualified employee stock purchase plan (ESPP), you may have shares you previously sold or currently own that are listed as a “disqualifying disposition,” without understanding how the tax consequences of a stock sale compare to those of a qualifying deposition. We’re going to break down the differences and explain how they impact your taxes.

One of the tax perks of participating in a qualified ESPP plan is that the discount (or bargain element) is not immediately taxable when you receive the shares. When the shares are sold, preferential tax treatment depends on two criteria being met:

1) Has more than one year passed since the purchase date?

2) Have more than two years passed since the offer date (sometimes described as grant date)

If one or both of these criteria are not met when the shares are sold, the sale is deemed a disqualifying disposition. The tax consequences may seem subtle, but can be meaningful:

• The discount element is taxable as earned income, regardless of the selling price. Let’s suppose your company stock is priced at $10 per share at the beginning of the offer period, $20 on the purchase date and you have had $1,700 withdrawn from your paycheck for ESPP. This means 100 shares are purchased with a discount is 15% (assuming no lookback period, which we’ll touch on later), then the total discount of $300 (purchase price of $20 - 15% discount * number of shares) is taxable as earned income, even if the shares are sold below the purchase price. For example, if the shares are sold at $18, then you would have earned income of $300, basis of $2,000 and a loss of $200 (short-term if it’s been one year or less since the purchase date).

Let’s contrast this to a qualified disposition with the same prices.

• With a qualified disposition, the discount element for tax purposes is the lesser of:

  • The discount at the offer date: purchase price of $10 * 15% discount * number of shares = $150

  • The sales proceeds – purchase price * number of shares (with the end result not to be less than 0): $18-$17*100 = $100

The end result in this example is earned income of $100 in the case of a qualifying disposition, compared to $300 in the case of the disqualified disposition. The disqualified disposition also includes the aforementioned $200 capital loss.

Now let’s talk about plans with a lookback period (which we love!). The lookback is beneficial because instead of automatically using the current price as the starting point, you use the lower of the price of at the beginning of the offer date, and the price on the purchase date. For example, if the stock is again priced at $10 at the beginning of the offer period and $20 on the purchase date with a 15% discount, instead of purchasing 100 shares at $17 per share as in the example above, this time we purchase 200 shares ($1,700 divided by discounted price: $10 - 15% discount).

The same logic applies from a taxability standpoint, with the disqualified disposition recognizing earned income on the entire discount ($10 * 15% or $1.50 per share), and the qualified disposition on the lesser of the discount on the offer date and the actual gain.

In summary, it doesn’t always make sense to hold your company stock until the qualifying disposition status is reached, but doing so may be beneficial from a tax perspective.

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