Employees of corporations that offer discounted stock purchases through Employee Stock Purchase Plans must use special tax rules to determine the cost basis of their shares. Purchase discounts of up to 15% off the current market price of the stock are allowed under Internal Revenue Code Section 423 ESSP plans. Discounts vary by employer.
Different rules apply based on whether the disposition is "qualifying" or "non-qualifying" under IRC Section 423 rules.
The general rule for qualifying IRC Section 423 ESSP plans is that you are not taxed on the discount until you sell the stock, but you must pay ordinary income tax on it. You are taxed on the discount or the actual gain on the sale, whichever is less. The discount amount is then added to what you actually paid for the shares to determine your cost basis, thus reducing your capital gain.
To be eligible for this favorable tax treatment as a "qualifying disposition," you must meet both of two conditions:
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1. You must hold the stock for two years from the Offering Date. (The Offering Date is often about three months before the Purchase Date--it is the date set by the company for the start of accumulation of payroll deductions for the ESSP purchase.) 2. You must hold the stock for one year from your actual Purchase Date.
Ordinarily, your employer will compute and report the ordinary income portion on your Form W-2. However, if they do not do so, it is your responsibility to calculate and report it.
Care must also be taken to apply the wash sale rules. This can easily occur if you sell any of your ESPP shares within thirty days before or after the ESPP Purchase Date for the current Offering Period.
Your employer will issue Form 3922 to you by January 31 each year to report the details of your discounted purchase. This form will document the elements of your tax basis in the shares. A sample of Form 3922 and related instructions can be downloaded by clicking on the "PDF" icon to the right. Use the information from Form 3922 in our ESSP calculator to compute your cost basis.
You will also need your Form 1099-B for the sales proceeds and date of sale.
If you are in a Section 423 ESSP but do NOT meet the eligibility standards for a qualifying disposition, the discount is still taxed as ordinary income, but it is not limited to the amount of actual gain. You then add the discount to the amount that you actually paid for the shares to determine your cost basis.
If your employer's stock purchase plan is not Section 423-qualified, you are not allowed to defer taxation of the discount at all. It is current compensation in the year you buy the stock, and your cost basis is the purchase price plus the discount. Unlike the Section 423 ESSP, you are not allowed to defer taxation of the amount of the discount until the shares are sold.
Comparison of ESSP Plan Tax Treatment
Section 423 Qualifying Disposition
Section 423 Non-Qualifying Disposition
Not a Section 423 Plan
Can taxation of discount be deferred until date of sale?
