There are several options available to encourage employees to have a personal stake in a company’s financial success. One of those options is an employee stock purchase plan or ESPP. It allows employers to offer employees stock in the company at a discount. Employee stock purchase plans differ from stock options since they involve the actual purchase of stock in the immediate future. There are three categories of income that each has their own tax implications:
· Return of Capital
· Capital Gain
Return of Capital
Any amount that was initially paid for the employee stock purchase plans is non-taxable. The stock purchases are made with after-tax dollars directly from the employee so there are no tax implications when this money is returned.
The market value of the shares purchased over the amount paid for the shares on the purchase date is the discount that employers offer. The discount is income earned by the employee and is taxed at ordinary income tax rates just like regular wages or salary. The timing of recognition of this income depends on the type of plan. Nonqualified plans force taxpayers to recognize this as income in the tax year the stock is purchased. Qualified plans, which are more common, only require income to be recognized when the stock is sold. It is important to check with your employer to see what type of plan they are offering. If taxpayers are still employees at the time income must be recognized then it will likely be included on a W-2. If the stock is sold after an employee leaves the company then reporting and paying the taxes can get more complicated.
The excess of the proceeds from the sale of the stock over the previous two items (return of capital and compensation) is treated as capital gain. Capital gain can be short term or long term. Short term capital gains are treated just like compensation and taxed at ordinary income tax rates. Long term capital gains for most individuals are taxed at 15% or even 0% depending on income levels. It is important to hold stock from employee stock purchase plans at least a year to get these preferential rates.
The good news is that most employee stock purchase plan administrators will do these calculations for you as they can be complex. However, it is important to understand the tax implications of participating in these plans. They are an increasingly attractive options for companies to compensate their employees without having to make a large cash outlay upfront.