Intentionally disqualifying Employee Stock Purchase Plans

Employee stock purchase plans (ESPPs) are, in short, amazing.  If you have access to one and your are not maximising it, you should take a second look.  They come with one giant downside, which is mitigated somewhat by intentionally disqualifying them. In simple terms, this means pulling out your money as fast as possible.

The downside of an ESPP is that you are duplicating savings and income sources, putting both eggs in the same basket, and increasing the magnitude of damage that can occur should something catastrophic occur to your company.  If you happen to be working for an Enron, you could see the value of your savings decrease to zero in little over a month, and while that happens, you lose your job.

How ESPPs work

An ESPP allows the employee to purchase company stock at a price discounted from the market.  The maximum discount is 15%, and the maximum value of shares that can be purchased in a given year is $25,000, governed by §423 of the IRS Code. This means that you’d max out at $21,250 if your company allowed you the 15% discount.

There’s a series of key events involved with an ESPP, which are reported on form 3922.  The events are important because they create the timer with regard to whether the disposition of the stock is a qualified, or disqualified event.

The employer will typically offer the following:

Enrollment Period

This is where you decide if you wish to participate in the ESPP, and how much of your paycheck to contribute.  Note that the deduction from your paycheck is after tax, unlike a 401(k) contribution.

Offering Period

Once you’ve decided to contribute, the paycheck deductions will build up during the offering period.  At the end of this time, you should be offered a final decision on whether you wish to go ahead and purchase the stock at discount, of if you want to take back your money.

Typically, the first day of the offering period is the Grant date, and the last day is the Exercise date.

ESPP Taxation

ESPPs are taxed in two different ways, depending on whether they are qualified, or disqualified transactions.  To determine if it is qualified or disqualified we look at the period of time elapsed since both the Grant date and the Exercise date, as follows:

Qualified Disposition

• The stock was sold at least 2 years after Grant Date
• The stock was sold at least 1 year after Exercise Date

Disqualified Disposition

• The stock was sold in less than 2 years from Grant Date
• The stock was sold in less than 1 year from Exercise Date

Note that there are two ways that disqualified disposition can arise:

1. Stock was sold in less than 1 year of Grant AND Exercise date
2. Stock was sold after 1 year of Exercise date, but BEFORE 2 years had elapsed from Grant date

Because of this, there are several different tax situations that can arise. I’ll go through all three using an example where someone purchased $10,000 of company stock at a discounted price of $8,500 to show the differences

Disqualified Short Term Gain

Scenario: Stock increases by 10% in the short term, making a value of $11,000, purchased for $8,500

By selling in less than a year from both Grant and Exercise you’re capturing a Short Term Capital Gain (STCG), treated as follows:

• Bargain Element = $1,500 (15% discount on $10,000) taxed as ordinary income (OI).  This should be reported by the employer on your W2, but if it is not, you still owe that tax. This tax is owed in the year of the sale, not the year of the grant.
• Short Term Gain = $1,000 ($11,000-$8,500+$1,500) – note that STCG are the same tax rate as Ordinary Income, though this element can be reduced via any harvested capital losses.

Total taxes owed = $1,500 of OI and $1,000 of STCG. At the 25% bracket this would equate to $625 taxes.

Disqualified Long Term Gain

Scenario: Stock increases by 10% in the long term, making a value of $11,000, purchased for $8,500

By selling in over a year from Exercise Date your capital gain portion of the tax will be at the more favorable Long Term Capital Gain (LTCG) rate, treated as follows:

• Bargain Element = $1,500 (15% discount on $10,000) taxed as ordinary income (OI).  This should be reported by the employer on your W2, but if it is not, you still owe that tax. This tax is owed in the year of the sale, not the year of the grant.
• Long Term Gain = $1,000 ($11,000-$8,500+$1,500) – note that LTCG are more favorable than Ordinary Income, though this element can be reduced via any harvested capital losses.

Total taxes owed = $1,500 of OI and $1,000 of LTCG. At the 25% bracket this would equate to $525 taxes.

Qualified Gain

There is no qualified short term gain scenario, because the rules state you must hold over 1 year to make the transaction qualified.  The qualified disposition advantage introduces the new terminology and tax treatment, where Ordinary income is calculated as the lesser of:

• The difference between the sale price of the stock and the discount price ($2,500) or
• The amount of the discount ($1,500)

Scenario: Stock increases by 10% in the long term, making a value of $11,000, purchased for $8,500

• Bargain Element = $1,500 (15% discount on $10,000) taxed as ordinary income (OI).  This should be reported by the employer on your W2, but if it is not, you still owe that tax. This tax is owed in the year of the sale, not the year of the grant.
• Long Term Gain = $1,000 ($11,000-$8,500+$1,500) – note that LTCG are more favorable than Ordinary Income, though this element can be reduced via any harvested capital losses.

Total taxes owed = $1,500 of OI and $1,000 of LTCG. At the 25% bracket this would equate to $525 taxes.

Parsing through the data

If you consider the three scenarios above, you will find that the Qualified Disposition (with Gain) is the same as Disqualified Disposition (with Gain).  This is because the difference between the two comes down to that clause of being able to use the lesser of two amounts.  However, by definition, the discount will always be less than the spread of discount+gain.

Therefore, once you’ve hit the 1 year mark, and turned the capital part of the tax from Short term into Long term, there is no taxable difference in the event of a gain.  As such, there is no benefit in holding beyond 1 year from a tax perspective.  If we wanted to intentionally disqualify after 1 year, why not do so after 1 day?

With a gain – Disqualified short term differs from the other two options in the same manner -the way in which the gain between exercise price and market price is taxed – at a rate equal to your income (STCG) or at the more favorable LTCG rate.  If we use the 25% OI bracket, that means a 25% STCG rate or a 15% LTCG rate, and 10% difference sounds like a lot of tax, but remember it only applies to gain.

If you sell the very first day that you possibly gain, your $10,000 in stock has been exposed to the market for just that one day.  Hopefully it doubles in value and you pay more tax, but more likely, it might move 1-2% depending on regular conditions.  If $10,000 goes up 2% it is now worth $10,200.

• $10,200 taxed at STCG rates = $50
• $10,200 taxed at LTCG rates = $30

So holding for the more favorable Long Term Disqualified means you save $20 in taxes for 1 year of risk, and holding for the apparently more favorable Qualified treatment means you save the same $20 but need to hold the stock for 2 years.  You’d be hoping that the price remained the same at least, so you are risking $10,200 in order to save $20 in taxes… doesn’t seem like the smartest play.

What about a loss?

The examples above explain a gain situation. In the event of a loss, the Qualified Disposition terminology kicks in, and allows you to take the lesser of the discount or the spread between discounted price and sale price. Using the same situation as above, if the sale price was lower, perhaps at $9,500….

• Ordinary Income of $1,000
• Capital Loss of $500

vs Disqualified

• Ordinary income of $1,500
• Capital Loss of $500

This is the only scenario where the qualification of the ESPP disposition offers tangible value on the income side of taxation, but if on day 1 of holding the price did drop $500 and you decided to wait another 2 years to sell in order to save $125 in income tax.. you’d be missing the point.

Conclusion

ESPPs are excellent, whenever possible people should be maxing it out, but don’t be afraid of the short term tax rates and ‘unfavorable’ taxation that comes with disqualifying the event.  The value from an ESPP is in the discount, take it, and run while minimising the risk that something goes wrong.