Tax Consequences Of Employee Stock Plans
My company offers both Non-Qualified Stock Options (NQSOs) and an Employee Stock Purchase Plan (ESPP). I was granted a number of NQSOs when I started with the company and I’ve recently joined the ESPP. The ESPP allows employees to buy company stock at a 15% discount to the fair market value (FMV) of the stock at the beginning of the period or the end of the period, whichever is lower. Periods run January - June and July - December. I view this as basically a CD with a 15% return. Every paycheck I put a chunk of money into the plan. At the end of the period that money is used to buy stock at a discount. If I immediately sell I have at least a 15% gain, it could be considerably more if the stock moves up during the period. I can’t touch the money during the plan period and it doesn’t earn any interest, but for the return I’m getting I don’t mind these minor drawbacks. I have no risk in this plan. At worst I get a 15% return.
NQSOs are a different beast. I hold a number of these options that have a specific strike price. They vest over time and it will be 5 years from my hire date before I’m fully vested in all the options. Under the current plan I should continue to receive new NQSOs each year as well. Whenever the market price of the stock is greater than the strike price of my options, I can exercise any vested options and get the difference between the strike price and FMV in cash. I have no risk in these options at all. If the market price is never above the strike price they’ll eventually expire worthless, but I’m not out any money.
Both of these sound great don’t they? However, there’s the usual catch…taxes. I don’t get all this extra money for free. Of course I have to pay taxes for participation in both of these plans. The tax treatment of each of them varies and can get pretty intricate. I’ll hit the highlights here but as always, consult a qualified professional if either of these situations applies to you.
NQSOs first. These have a fairly simple tax treatment. The difference between the strike price and FMV when they’re exercised is reported as regular income on my W2 at the end of the year. The commission I have to pay on the transaction becomes an investment expense I can write-off, subject to the 2% floor for miscellaneous deductions. The tax bite here could be large if I exercise a lot of options at a big gain. Alas this isn’t something I need to worry about because I have none vested and they’re underwater anyway. The tax consequences of NQSOs change dramatically if they are exercised and held, or exercised at a loss. Because this rarely happens, and I’m not a tax professional, I won’t go into these situations here. A large gain from NQSOs can also trigger the dreaded Alternative Minimum Tax (AMT). If you are lucky enough to have exercisable NQSOs, be sure you understand the impact of the AMT. Better yet, seek professional advice.
Now for the ESPP. This situation is a bit more complicated. The income on these shares can be taxed at different rates, depending on what happens after the shares are purchased by the plan. There are both qualifying dispositions and disqualifying dispositions for these shares. In order to have a qualifying disposition, the shares need to be held for at least two years from the beginning of the plan and for at least one year from the purchase date. A qualifying disposition allows you to be taxed at the long-term capital gains rate. If you do not meet both of these criteria, the sale of the shares is considered a disqualifying disposition and you are taxed at the short-term capital gains rate, which is generally your nominal income tax rate. However, like with NQSOs, the difference between your purchase price and the FMV of the stock on the purchase date is reported as earned income on your W2.
To summarize:
- NQSOs - taxed as earned income when exercised for a gain.
- ESPP - difference between plan purchase price and FMV taxed as earned income. The difference between the market price on the purchase date and the sale price is taxed as capital gains, either long-term or short-term depending on holding period of the shares. You can take a loss on these shares for tax purposes.
My plan: I intend to hold onto my NQSOs for the foreseeable future, not exercising any once they become vested. Not only is the market price of my company stock well below the strike price of my options, but I don’t have need of the money any time soon. I hope to eventually pay off our HELOC with these options, so I hope the stock price rises as they vest. If that is the case I may exercise them over a period of time, sort of a reverse dollar-cost-averaging strategy. I’m using the ESPP as a savings account with a great return. I intend to sell these shares immediately and use the money in our debt payoff plan. I decreased my paycheck witholdings this year expressly for this purpose. My company reports the ESPP earnings to the IRS but doesn’t withhold any taxes. I’m having more taxes taken out of my paychecks so I don’t have a large tax bite at the end of the year.
These stock plans are a great way to boost my job-related income, and I’m thankful they’re both available to me. I’d be throwing away money by not participating in the ESPP and the NQSOs have the potential to bring me a good-sized financial windfall. Again, I’m not a tax professional and you should seek the advice of one if either of these situations applies to you.