Tax planning and compliance for investors
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By Kaye A. Thomas
Updated April 9, 2011
Reporting compensation income and capital gain or loss for a qualifying disposition of ESPP shares.
If you hold shares from an employee stock purchase plan long enough to avoid a disqualifying disposition, you still may have to report some or all of your profit as compensation income when you sell or otherwise dispose of the shares. If you have additional profit beyond the amount reported as compensation income, it is reported as capital gain. This page explains how to report these events.
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These rules impose reporting requirements on a disposition of ESPP shares that occurs after you have held the shares long enough to avoid a disqualifying disposition. Unlike the rules for incentive stock options, these rules may require some or all of your profit to be reported as compensation income even after you've satisfied the holding period requirement. The amount of compensation income is calculated differently than for a disqualifying disposition, using the lesser of two numbers. Strangely, it is possible (although unusual) for the amount of compensation income to be larger for a qualifying disposition than it is for a disqualifying disposition.
The law on this issue is poorly written and causes plenty of confusion among the companies that maintain these plans, the individual participants and their tax preparers. Even the IRS has sometimes appeared to be confused about this rule, stating it incorrectly in Publication 525. The description here is based on the rule as it appears in the tax law, specifically section 423(c) of the Internal Revenue Code.
Income from a qualifying disposition of ESPP stock may or may not appear on Form W-2, so that is one item you need. If you sold the shares (instead of making a different kind of disposition, such as a gift), you should also have Form 1099-B, which reports your proceeds from the sale. In addition, you need information provided on Form 3922, which employers are required to provide beginning with the 2010 tax year.
Your compensation income from ESPP shares in a qualifying disposition is the lesser of two amounts.
The first is the discount allowed on your purchase, determined as of the "grant date," which is normally the first day of the offering period. (Your company should inform you if a different grant date is used.) Note that this is not necessarily the actual discount you received on the shares. It's the discount determined as if you bought the shares on the grant date, even though you didn't buy the shares that day and couldn't have done so even if you wanted. Beginning with the 2010 tax year, you should find the numbers needed to calculate this amount on Form 3922 supplied by your employer. It's the difference between the fair market value of the stock on the grant date and the purchase price determined as of the grant date (not the actual purchase price).
The second number, which comes into play only if smaller than the first one, is essentially your profit from the shares. More precisely, it's the difference between the fair market value of the stock when you disposed of it (normally your sale price, but you would need to find the value if you disposed of the shares without selling them, such as a gift or donation) and the actual amount you paid for the shares.
The smaller of these two numbers (the discount or the profit) is the amount of compensation income you have as a result of the disposition.
The compensation income from a qualifying disposition may be reflected on Form W-2 received from the company maintaining the plan. That doesn't always happen, so you should check your W-2. It may be difficult to isolate this amount because it is not listed separately. One clue would be to compare the number in box 1 (your total wages) with the number in box 3 (social security wages), because this income should appear in box 1 but not in box 3. If you're uncertain about whether the company included this amount in your wages reported on form W-2 you should clarify this with the payroll department.
If the compensation income from your qualifying disposition was included in the wages reported on Form W-2, simply report the number from your W-2 on your tax return the way you normally do. If it was not included on your W-2, add the ESPP compensation to the wages on your Form W-2 and report the total as wages on your tax return.
Some people worry that they need to attach an explanation if the number for wages on Form 1040 doesn't match the number on the attached Form W-2. That isn't necessary here because the number you're reporting is greater than the number on Form W-2.
Next you need to calculate your basis for the shares. This is the amount you paid for the shares, increased by the amount of compensation income reported. If your qualifying disposition was a gift, you should provide this basis information to the recipient of the gift. If the disposition was a sale, proceed to Step 5.
Report the sale of the shares on Schedule D, using the sales proceeds reported on Form 1099-B and the basis calculated in Step 4. You had to hold the shares more than a year (and perhaps longer) to have a qualifying disposition, so your gain or loss is long-term.
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