Saturday, February 11, 2012

Avoiding double taxation on ESPPs

Ah, tax season. Every year, it seems like I'm affected by some new little trick or trap. This year it's my company's ESPP—employee stock purchase plan. It's an incentive provided by the employer to induce employees to purchase stock of the company itself. An example ESPP plan might let its employees put up to 10% of each paycheck directly into company stock, bought at a 10% discount.

One interesting aspect of these plans is the complex taxation mechanisms surrounding it. In the specific case that you sell the purchased stock within a year after acquiring it, you might end up being double taxed on some of the money you earn! Here's how:

Bill is an employee of the infamous XYZ Corp. He sets aside 10% of his $4,500 monthly paycheck, or $450, to participate in the company's ESPP. On the day the shares are purchased (e.g., March 31), the stock is trading at a price of $10. After the 10% discount, employees are buying at $9. Bill's $450 goes to purchase 50 shares of XYZ corp. (My, what nice round numbers!)

Here, we must take a brief aside into the Land of Arcane Calculations. For tax purposes, we must compute just how much of a benefit the ESPP gave the employee, or the "bargain element". This is the difference between the fair market value (FMV) of the stocks at purchase (50 * $10 = $500) and the actual price paid for them ($450). For Bill, the bargain element is $50. (This will be important later, like next February.)

All right, so now Bill holds the XYZ shares for six months, during which time XYZ Corp. does great, and the share price skyrockets to $12. (Whoo!) Bills sells his 50 shares at a healthy gain, for $600. All's well, right? (Side note: The IRS argot calls any such sale after less than a year a "disqualifying disposition".)

Early next year, Bill starts receiving his tax reporting forms. First comes the W-2. As per the IRS guidelines, XYZ Corp. monitors the sale of the shares given in its ESPP plan, and it includes the bargain element of the sale (that $50 we computed earlier) as part of his gross income. (If XYZ is like my employer, it's not itemized, either, so Bill will have to be diligent to notice it.)

Next, Bill gets a 1099-B statement from his brokerage. The brokerage reports that since Bill bought 50 shares at $9, then sold them at $12 within a year, he has $150 of short-term gains.

Okay, notice the sneaky double taxation? The bargain element has been included as income on both the W-2 and the brokerage statement. (Also, note that if this is a semi-monthly occurrence, the double-reported income for the year will total $1,200—no small chunk of change.)

After introducing the problem, I won't endeavor to solve it here, as it's already been done excellently by*). But if you participate in an ESPP (and if you can, you should), be aware of this little taxation trap.

(*) Short version: alter the basis reported by the brokerage to reflect FMV, then tell the IRS that you did so.