ESPP Income Tax Implications

Section 421 of the Internal Revenue Code (the "Code") provides special rules for determining the income tax treatment of the transfer of shares in connection with the exercise of an option or purchase right that meets the requirements of Section 423(a) of the Code.

Qualifying Tax Treatment
Participants will not realize taxable income when the company grants an option to purchase shares under the terms of a qualified ESPP or when those shares are actually purchased.
To qualify for favorable tax treatment on the sale, transfer or other disposition of shares acquired under the ESPP, the disposition may not occur before the later of:
  • One year after the purchase date.
  • Two years after the beginning of the applicable offering period or grant date (other than a disposition resulting from the participant’s death).
A disposition of shares that meets this required holding period is generally referred to as a qualifying disposition. If the shares are held for the required holding period, the participant will be subject to ordinary income tax in the year in which the shares are sold on an amount equal to the lesser of:
  • The applicable discount from the fair market value of the shares on the offering date.
  • The excess of the sale price for the shares that are sold (or in the cases of death or other disposition, the fair market value of the shares on the date of death or other disposition) over the purchase price for the shares.
The participant must also recognize capital gain or loss in the year of sale. The amount of gain is equal to the difference between the sale price and the sum of the purchase price, plus the amount of ordinary income calculated above. The amount of loss is equal to the difference between the purchase price and the sale price.
If the shares are held for the required holding period, the employer will not be entitled to a deduction for federal income tax purposes on the grant or exercise of the option.
Unlike ISOs, with ESPP shares, the excess of the share’s fair market value over the amount paid for the shares is not an alternative minimum tax ("AMT") preference item. 
Disqualifying Tax Treatment
If a participant does not satisfy the required holding period, then the excess of the fair market value of the shares on the purchase date over the purchase price is recognized by the participant as ordinary income at the time of the sale or other disposition. In this case, the employer is entitled to a tax deduction in an amount equal to the ordinary income recognized by the participant. As with a qualifying disposition, capital gain or loss must also be recognized in the year of sale. The amount of gain or loss is equal to the difference between the sale price and the sum of the purchase price plus the amount of ordinary income calculated above.
If the ESPP does not require participants to hold the shares acquired on exercise for the duration of the holding period, then it should require participants to notify the company of any disqualifying disposition. This allows the company to:
  • Take any deduction associated with the disposition.
  • Properly report any amount that may be included as income on the participant’s Form W-2.