Straight Talk on ESPP Disqualifying Dispositions

As a lifelong fan of broad-based ownership programs and the #1 cheerleader of ESPPs, I'm going to say something that may sound shocking. Qualified dispositions are overrated. 

How Valuable Is a Qualifying Disposition, Really? 

When we talk about disposition of ESPP shares we often talk about the qualified disposition as if it is a pot of gold at the end of the proverbial rainbow. But it's time that we take a good look at that assumption.  How big is that pot of gold?  Spoiler alert. Your highest paid employees stand to benefit the most from a qualified disposition, while the more modest tax benefit for many of your employees may not outweigh the market risk of holding shares simply for better tax treatment.   

Let's zoom out and remind ourselves what the benefit of a qualified disposition is.  A qualified disposition generally allows more of the income from the spread on the purchase to be treated as capital gain and less as ordinary income.  The spread on purchase is the difference between what the employee pays for the share and what it is worth on the date of purchase.  

Example:  A Section 423 ESPP offers a 15% discount and a lookback. At the beginning of the 6-month offering period, the stock price is $10, and at the end, the stock price is $15.  Employees buy shares at $8.50, when the stock price is $15.  Wow. That is a big spread on purchase.  $6.50/ share to be exact.  Many may innately believe that holding these shares to qualified status will provide important tax savings since capital gain rates are lower than ordinary income rates.  But how does this really play out? 

Comparing Tax Rates: Ordinary Income vs. Capital Gains 

The IRS kindly lays out the 2024 ordinary income rates for us: 

And the 2024 capital gains rates: 

• 20% for incomes over $518,900 (over $583,750 for married filing jointly) 
• 15% for incomes $47,026-$518,900 ($94,051-$583,750 for married filing jointly) 
• 0% for incomes up to $47,025 ($94,050 for married filing jointly) 

An Example of How the Tax Savings Plays Out for ESPP Qualifying Dispositions 

Let’s walk through an example. As noted above, here are the details of our ESPP: 

Now, let’s look at two hypothetical employees.  Let’s call them Emily C. and Barbara B.: 

Emily makes $75,000 a year, as does her husband, and files jointly. 

• 22% Ordinary income rate
• 15% Capital gain rate  

Barbara makes $500,000 a year, as does her husband, and files jointly. 

• 37% Ordinary income rate 
• 20% Capital gain rate  

Based on these facts and assuming that Emily and Barbara sell their shares at a price that is higher than the $15 FMV on the purchase date, we can see the per share ordinary income and capital gain for both types of dispositions.  

Income for ESPP Dispositions

So, while the tax savings of a qualified disposition for the highly paid Barbara is a meaningful 35%, that shrinks to 24% for the modestly paid Emily.   

How Did We Calculate the Taxes Paid Per Share? 

Calculating the taxes per share on the disqualifying disposition is easy; it’s just the ordinary income per share on the disposition multiplied by the employee’s ordinary income tax rate. For the qualifying disposition, multiply the ordinary income and capital gains per share by their respective tax rates, then add the results together to come up with the total tax per share. 

Tax Savings vs. Market Risk: Is It Worth It? 

Is a 24% tax savings worth the market risk of holding the shares 18-21 months, which is required for most plans to achieve a qualified disposition?  With a modest income of $75,000 a year, would Emily be better off selling the shares in a disqualified disposition and using those proceeds to pay down high interest rate debt?  (The math here is complicated enough but suffice it to say that 28% APR on credit card debt is bad news and paying that down should be a number one priority rather than seeking tax qualification on ESPP shares.)  Could Emily be better served disqualifying her ESPP shares and using the proceeds to establish an emergency fund?  Once employees enroll in the ESPP, they typically stay in the ESPP. So, even if Emily sells her shares, she can continue, or even amplify her ownership mindset.  As an on-going ESPP participant, she still has a vested interest in the company’s success, and using her ESPP gains more quickly in ways that can positively impact her overall financial wellbeing may even amplify the perceived value of this plan. 

Not sold?  Let’s keep playing out this scenario.  With a $75,000 salary, Emily contributes 5% of her pay, $3,750/year, or $1,875/purchase period. So, she purchased 220 shares, and her gain on purchase is $1,430 (220 shares multiplied by $6.50 per share).  In a disqualifying disposition, she owes $315 in taxes ($1.43 per share in taxes multiplied by 220 shares).  In a qualified disposition, she owes $238 ($1.08 per share in taxes multiplied by 220 shares).  So, in real dollars, we are talking about a $77 tax savings.  Whereas Barbara, with her $500,000 annual salary, contributes $12,500 in the purchase period, with the same 5% contribution level, and buys 1,470 shares. For Barbara, a DD would result in a $3,543 in taxes ($2.41 per share in taxes multiplied by 1,470 shares), compared to $2,293 for a QD ($1.56 per in taxes multiplied by 1,470 shares), which represents a $1,250 tax saving. 

For simplicity, tax amounts are rounded to whole dollars.

Could ESPP Taxation Get Any More Complicated? You Bet It Could! 

My example focuses only on the spread at purchase. It’s likely that employees will recognize an additional gain or loss on their dispositions; that gain or loss complicates the tax analysis. If the employee recognizes a gain that is short-term in the DD scenario and long-term in the QD scenario, that will increase the tax savings in the QD scenario. If the employee has a loss on the sale, the loss will reduce the income in the QD scenario but may not have the same effect in the DD scenario.  

And don’t even get me started on the quirky situations. What?!?  You don’t know about the peculiar results in a down market?  Let me enlighten you.  For a plan that has a lookback, the purchase price is determined based on the lower of the beginning or ending price.  If the stock price is lower at the end of the purchase period, the lower end price is used to calculate the purchase.  But Section 423 defines the ordinary income for a qualified disposition based on the begin price, even if it is higher and not used for calculating the purchase price. The result is that in a down market it is possible to get a better tax result with a disqualifying disposition.  (See the NASPP article “Taxation of Section 423 Qualified ESPPs,” to learn more about how ESPPs are taxed.)  

One thing is certain. Section 423 plans are complicated. (You know what is a lot less complicated? A nonqualified ESPP. If this hasn’t convinced you that an NQ plan might be worth a look, the NASPP can give you ten other reasons to consider a nonqualified ESPP.) And employees need and want help when it comes to knowing when to sell their shares.  Only half of employees in their ESPP feel confident in knowing when to sell their shares and three quarters of employees want help with this topic. And first-time stockholders (a whopping 40% of ESPP participants are first time stockholders!)  are even more interested in this type of education.     

To help with this need, I’ve recently introduced a piece to raise some of these issues to employees in an effort to help them understand important considerations when it comes to selling ESPP shares.  

What do you think?  Are qualified dispositions overrated? There’s nothing I love talking about more than ESPP, so if you have thoughts on this, I’d love to hear from you. My inbox is always open for ESPP discussions.  Emily.cervino@fmr.com