The taxation of employee stock purchase plans is confusing. After you sell ESPP shares, the taxes you owe depend on various factors, including the purchase price, the market price at purchase, the price at the start of the offering, the discount, how long you held the stock, and the price at sale. In this blog entry, we present some common tax-return mishaps involving ESPPs and explain how you can avoid them. Understanding these points will help you prevent overpaying your taxes or (perhaps worse) provoking the annoyance of the IRS for underpaying.
Form 3922 Can Help
ESPP purchases in a given tax year are reported on IRS Form 3922 for ESPPs. The form, which your company should issue before the end of the January after the year of purchase, helps you collect information for reporting sales of the shares on your tax return. The forms also give the IRS information about your transactions. For details, see the related FAQ on myStockOptions.com.
Alert: For stock sold during 2011 and later, you must file with your tax return the new IRS Form 8949 along with Schedule D, which has significantly changed upon the introduction of Form 8949. This change stems from the expansion of the information that brokers must report to you on IRS Form 1099-B. The information on Form 3922 can help you calculate the cost basis of your ESPP stock if the cost basis is omitted or too low on Form 1099-B.
Common ESPP Errors On Tax Returns
1. Not filing Form 8949 after an immediate sale of ESPP shares at purchase. With an immediate sale of your ESPP shares at purchase, the discount is reported on your W-2 and on your tax return as ordinary income. Even though you never held the stock (or at least not for long) after purchase, you still need to report this sale transaction on Form 8949 and Schedule D, which are used to report capital gains and losses on all stock sales. You may even have some small gains or losses, depending on how your company calculates the discount at purchase, how long it takes for the shares to become available in your account, and any commissions and fees for the stock sale. For an annotated example showing how you report this on these forms, see a related FAQ on myStockOptions.com.
Alert: If the IRS were to receive a report of your gross sale proceeds from your broker (on Form 1099-B) but without a corresponding report of the sale on your Form 8949, it would think you had failed to report the gain on the sale. Assuming a tax basis of $0, the IRS computers would then automatically send you a notice for the taxes due.
2. Paying tax on the discount too early. Depending on the design of your company's ESPP, Section 423 of the Internal Revenue Code lets you buy company shares through after-tax payroll deductions at a discount of up to 15% off the fair market value of your company's stock. You should not include the discount as part of your taxable income for the year of purchase unless you also sold the shares in the same year. When you don't satisfy the ESPP holding periods, you have compensation income in the year of sale equal to the spread at purchase, i.e. the difference between the fair market value of the stock on the purchase date and the discounted price you actually paid for it.
For sales of stock from ESPPs that are not tax-qualified under IRC Section 423, the taxation, along with the potential reporting mistakes, is similar to that for NQSOs. The income would be reported, and would appear on your W-2, in the year of purchase, regardless of whether you sell the stock. See the section ESPPs: Taxes Advanced for details and examples.
3. Directly using what appears as the cost basis on your Form 1099-B. The expanded Form 1099-B does not need to report the compensation element of your cost basis, and the basis does not need to be included for stock that was purchased before 2011 (see a related article for details). This means you must check the accuracy of the basis and make any necessary adjustments in the 1099-B data that you transfer to Form 8949.
Alert: If compensation income is not part of the tax basis reported in Box 3 on Form 1099-B, make an adjustment in column (f) of Form 8949 and add code B in column (b). Should Box 3 be blank, report the full basis in column (f).
See the section Reporting Company Stock Sales for annotated diagrams of Form 8949 for ESPP stock sales.
Only The Beginning
For six other tax-return blunders involving employee stock purchase plans, see the FAQ on myStockOptions.com that gives full coverage to this topic. Need more background before you proceed? Listen to an engaging summary of basic ESPP concepts in our podcast about employee stock purchase plans. For a general overview of the new developments in IRS forms and reporting for the 2012 tax season, see our special tax-season video.