Monday, February 8, 2010

Tax Reporting for Qualifying Dispositions of ESPP Shares

FW from http://www.fairmark.com/execcomp/espp/qualifying.htm
By Kaye A. Thomas

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.

Preliminary explanation

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 is confused about this rule: they state 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.

What you need

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 two pieces of information:

  • The discount allowed on the stock, determined as of the beginning of the offering period (even though your purchase occurred at the end of the offering period), and
  • Your profit as of the date you disposed of the shares.

Discount allowed

If the first item above is zero, you don't have to report any compensation income on a qualifying sale of the shares. If the company provides a discount, you have to determine the dollar amount as of the beginning of the offering period. You may need help from the company to come up with this number, because it isn't always easy to determine the amount.

Example: Your company provides a 15% discount on ESPP shares. During an offering period you contribute $850 and acquire 25 shares having a value of $40 per share (total of $1,000) as of the end of the offering period.

This is not enough information to determine the dollar amount of the discount as of the beginning of the offering period. The shares might have been trading at $36 (total of $900) at the beginning of the offering period, and in that case the number we're looking for would be $135 (15% of $900). It doesn't matter that your actual discount ended up being $150.

Profit

Your profit as of the date of disposition is the difference between the value of the shares on that date and the amount you paid to buy them. If your disposition was a sale, use the sale proceeds as the value. If the disposition was a gift, or occurred as a result of the death of the employee holding the shares, determine the value of the shares based on the average of the high and low trading prices for the day of disposition.

If you sold shares that were acquired on multiple occasions, you'll need this information for each block of shares you acquired.

Step 1: Calculate compensation income

Your compensation income from ESPP shares in a qualifying disposition is the lesser of the two amounts described above. If the company provides no discount on the shares, the compensation income is zero. Likewise, in a qualifying disposition, if you have no profit as of the date of disposition, you don't report any compensation income. This is a significant difference from a disqualifying disposition, where you generally have to report compensation income even if you do not have a profit.

Step 2: Check your W-2

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.

Step 3: Report your compensation income

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.

Step 4: Calculate your basis

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.

Step 5: Report the sale of the shares

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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