August 2006

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Tax Reporting for Disqualifying Dispositions of ESPP Shares

I get many questions about the tax ramifications of disqualifying qualified employee stock purchase plan (ESPP) transactions. First, let’s define disqualifying disposition.

Disqualifying Dispositions

The amount of compensation income you report depends on whether your disposition is a disqualifying disposition. In general, this is any disposition (sale or gift) unless both of the following are true:

It is more than a year after the purchase of the shares, and
It is more than two years after the beginning of the offering period.

Many of these plans have an offering period of less than a year. In that case, holding the shares a year and a day won't be long enough to avoid a disqualifying disposition.

If you make a disqualifying disposition of shares acquired through a qualified employee stock purchase plan (ESPP), it usually means you have to report compensation income. If your disposition took the form of a sale, you'll also have to report capital gain or loss from that transaction. The following explains how to report these events.

Preliminary Explanation

These rules require you to report compensation income on a disqualifying disposition even if you ended up selling the shares at a loss. The compensation income is added to the basis of the shares that is used to calculate capital gain or loss, so that you don't get taxed twice on the same income. In some cases, however, you may not be able to use the capital loss from your sale. If that happens, you may be taxed on income that exceeds your profit, or even pay tax when you have an overall loss.

What You Need

Income from a disqualifying disposition of ESPP stock should 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 amount you paid for the shares, and
The value of those shares on the date of purchase (the last day of the offering period).

Your company should be able to supply this information if you do not already have it in your records. The value of the shares is usually determined by taking the average of the high and low prices for the stock on the last day of the offering period, but your company may use a different method.

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 disqualifying disposition is the value of those shares on the date of purchase minus the amount paid for them. For example, if you paid $1,700 to acquire shares that had a value of $2,000 on the date of purchase, your compensation income from a disqualifying disposition of those shares is $300.

In a disqualifying disposition of ESPP shares, you must report compensation income even if the stock value went down before you sold the shares, leaving you with a loss.

Step 2: Check Your W-2

This amount should 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, sometimes, 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 disqualifying 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. (It should also be equal to the value of the shares on the date of purchase, because compensation income is the value of the shares minus their cost.) If your disqualifying 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. If you held the shares more than a year, your gain or loss is long-term. For shares held a year or less, your gain or loss is short-term.

The information presented in the Tax Newsletter is only of a general nature, may omit many details and special rules, is current only as of its published date, and accordingly, cannot be regarded as legal or tax advice. Please contact your tax advisor for more information on the subject and how it pertains to your specific situation.

For more informationSee Investopedia's ESPP information.