Section 423 ESPP Tax Benefits: Qualifying vs. Disqualifying Dispositions

Section 423 employee stock purchase plans (ESPPs) can offer great tax benefits to US employees, but to obtain these benefits, certain rules must be followed. This post explains these rules, the tax benefits available to employees, and the tax implications of both qualifying and disqualifying dispositions.

What Are the Tax Benefits of Section 423 Qualified ESPPs?

ESPPs that are qualified under Section 423 offer several key tax benefits to US employees:

• Tax deferral: Participants don’t recognize any income or pay any tax related to their participation in the plan until they sell the shares they acquire under the plan. This means participants don’t have to pay any tax until they have sale proceeds they can use to fund their tax obligation.
• No tax withholding: Qualified ESPPs aren’t subject to tax withholding. This reduces the administrative burden of the plan for the company and allows participants to use those funds for other purposes up until they file their tax return. However, participants may view this benefit as a disadvantage if it results in an unexpectedly high amount of tax due with their return.
• No FICA taxation: Qualified ESPPs are exempt from FICA taxes. Participants pay less tax in a qualified ESPP than they would in a nonqualified plan because they won’t have to pay Social Security or Medicare tax on the shares they acquire under the plan.

In addition, if employees hold the shares acquired under the plan long enough, the disposition qualifies for the following benefit:

• Income tax reduction: A portion of the gain on their sale that would normally be treated as ordinary income may be recharacterized as a long-term capital gain, which is subject to a maximum individual tax rate of only 20%, compared with a maximum of 37% for ordinary income and short-term capital gains.

What Is Required for an ESPP to Qualify for Preferential Tax Treatment?

For an ESPP to qualify for the benefits described above, the plan must meet conditions set forth in Section 423 of the Internal Revenue Code, such as:

• Restrictions on who can participate in the plan and which employees must be allowed to participate
• A requirement that all participants receive equal rights and privileges under the plan
• Limitations on the amount of discount offered under the plan, the length of the offering period, the transferability of participation rights, and the amount of stock employees can purchase per year
• A requirement that the plan be approved by the company’s shareholders

For more information on these requirements, see the NASPP article “Designing an Employee Stock Purchase Plan.”

What Is the ESPP Statutory Holding Period?

As mentioned above, employees who hold the shares they acquire under the plan long enough can potentially reduce the tax they pay on their ESPP shares. To qualify for this treatment, employees must hold the stock for both of the following periods:

1. Two years from the start of the offering
2. One year from the purchase date

These periods are specified in Section 423, so we refer to them as the “statutory holding period.” When employees satisfy this period, we say their disposition is “qualifying.” Dispositions of shares that occur before either of the above periods has elapsed are “disqualifying.”

For more information on how ESPPs are taxed, see the NASPP article “Taxation of Section 423 Qualified ESPPs.”

How Are ESPP Qualifying Dispositions Taxed?

In a qualifying disposition, employees recognize ordinary income equal to the lesser of:

• The discount on the offering begin date, or
• The actual gain on the disposition

Let’s look at some examples. Say an employee enrolls in an ESPP offering when the FMV is $10 per share and purchases stock when the FMV is $15 per share. The purchase price in the plan is calculated at a 15% discount off the lower of the FMV on the offering begin date or the purchase date, resulting in a price of $8.50 per share.

Disposition Price Is $10 or Higher

If the employee disposes of the shares at $10 per share or higher, the employee will recognize $1.50 per share of ordinary income on the disposition. Any gain on the disposition in excess of $1.50 will be a long-term capital gain. For example, if the employee sells the shares for $22 per share, the employee will report a long-term capital gain of $12 per share.

Disposition Price Is Less Than $10 but Not Less Than $8.50

If the employee disposes of the shares at a price that is less than $10 per share, the actual gain on the disposition will be less than $1.50. It doesn’t make sense to make the employee pay tax on $1.50 when the employee’s gain is less than this amount. And while it is true that there are plenty of times the tax code doesn’t make sense, this isn’t one of them. As a result, the employee’s ordinary income will be limited to the actual gain on the sale.

For example, if the employee sells the shares at only $9 per share, the employee would recognize ordinary income of $0.50 and would not report any capital gain or loss.

Disposition Price Is Less Than $8.50

If the employee disposes of the shares at less than $8.50 (the purchase price), the employee will report only a long-term capital loss. For example, if the employee sells the shares for $7.50, the employee would report a loss of $1.

How Are ESPP Disqualifying Dispositions Taxed?

When employees dispose of their ESPP shares in disqualifying transactions, they will recognize ordinary income equal to the spread or gain that existed at the time they purchased the stock. This will be the difference between the FMV of the stock on the purchase date and the purchase price.

In the case of disqualifying dispositions, there isn’t a special rule that limits ordinary income to the actual gain on the sale. This can cause employees to recognize larger losses more frequently for disqualifying dispositions than they do for qualifying dispositions.

Let’s look at the same example we used above, but this time assume the shares are disposed of in a disqualifying transaction.

Disposition Price Is $15 or Higher

If the shares are disposed of at a price of $15 per share or higher, the employee recognizes ordinary income of $6.50 per share. Any additional profit is treated as a capital gain, which will be long term only if more than a year has elapsed since the purchase date. For example, if the employee sells the shares at $22 per share, the employee will recognize a capital gain of $7 per share, in addition to the ordinary income of $6.50 per share.

Disposition Price Is Less Than $15

Disposing of the shares at a price of less than $15 per share has no effect on the ordinary income recognized for the transaction (this is one of the times when the tax code does not make sense). The employee still recognizes ordinary income equal to the spread at the time of purchase and must report a capital loss for the difference between the disposition price and the FMV on the purchase date. The loss will be treated as long term if at least a year has elapsed since the purchase date.

For example, let’s say the employee sells the shares at $9 per share. The employee will still recognize ordinary income of $6.50 per share and will report a capital loss of $6 per share.

Are ESPP Qualifying Dispositions Worth the Wait?

As you can see from these examples, meeting the statutory holding period can enable employees to convert a substantial portion of the profit recognized on the disposition from ordinary income to a long-term capital gain. If the stock has declined in value since the purchase date, it can also prevent employees from paying tax on a gain they will never realize.

Despite this, qualifying dispositions aren’t necessarily all they’re cracked up to be. Various factors, including the stock price trajectory, the time value of money, and employees’ own personal tax brackets, can minimize or eliminate the advantage of qualifying dispositions. Moreover, employees are taking on the risk of a concentrated stock position for the duration of the holding period. Ultimately, employees’ financial goals and tolerance for risk, not the tax treatment, should drive their decisions to hold or divest the stock. The NASPP blog post “Straight Talk on ESPP Disqualifying Dispositions” provides a more in-depth analysis of qualifying vs. disqualifying dispositions.

What Counts as an ESPP Disposition?

In most cases, dispositions are sales of the stock acquired under an ESPP. But dispositions can include other transactions in which beneficial ownership of the stock is transferred, such as gifts and even donations of the stock to charitable entities.

A transfer of shares to an employee’s estate or beneficiary upon death is treated as a qualifying disposition of the shares, regardless of how long the shares have been held.

What Are the Company’s Reporting Obligations for ESPP Dispositions?

Although companies do not withhold taxes on dispositions of ESPP shares, they are still required to report the ordinary income employees recognize on both qualifying and disqualifying dispositions on Form W-2.

If the disposition is the first transfer of legal title of the shares, the company also must report it on Form 3922. In most cases, however, this reporting obligation is met at the time of purchase. See the NASPP article “Section 6039 Filings: A Complete Guide” for more information on Form 3922.

Learn the Essentials of Employee Stock Purchase Plans

ESPPs are a great way to reward employees, but for those unfamiliar with these programs, ESPPs can be intimidating to implement and administer. Our Employee Stock Purchase Plan Essentials course helps you build the foundation you need to confidently manage an ESPP.