Are Your Employees Being Overtaxed on Their Equity Compensation? Understanding Cost Basis and ESPP Taxation

Equity compensation plans, such as Employee Stock Purchase Plans (ESPPs), are valuable tools for attracting and retaining top talent. However, the tax implications associated with these plans can be a source of confusion for employees, leading to costly mistakes.

One of the most common issues employees face is misunderstanding their cost basis, which can result in overpaying taxes. This article will explore the intricacies of cost basis, its impact on taxation, and how employers can better support their employees.

What Is Cost Basis?

Cost basis is the starting point for calculating the gain or loss on the sale of equity awards. It represents the value of the shares at the time of purchase, grant, vesting, or exercise, depending on the type of equity compensation. For ESPPs, determining the correct cost basis is essential to ensure employees don’t pay more taxes than necessary.

How ESPP Taxation Works

Here’s a simplified breakdown of how ESPP taxation is structured:

1. The Discount Is Taxed as Ordinary Income:
   • The discount employees receive when purchasing shares is included in their W-2 as taxable income. (For example, if the stock is purchased at a 15% discount, the discount amount is taxed as ordinary income.)
2. Short-Term vs. Long-Term Capital Gains:
   • If shares are sold within two years of the grant date or within one year of the purchase date, any additional gain is taxed as short-term capital gains.
   • If shares are sold after meeting both holding periods, any additional gain is taxed as long-term capital gains, which typically have lower rates.

The Cost Basis Challenge

While the tax rules themselves are straightforward, the issue arises with the cost basis reported on employees’ tax forms:

• Employees receive a 1099-B form that includes a cost basis. However, this cost basis often excludes the discount amount that has already been taxed as ordinary income.
• Employees must refer to the 3922 form, provided by the plan administrator, to determine the correct adjusted cost basis, which includes the discount.
• If employees fail to make this manual adjustment on their tax return, they risk being taxed again on the discount, leading to an overpayment of taxes.

A Real-World Example

Consider an employee who purchases ESPP shares at a 15% discount. Here’s how their taxable events play out:

1. Purchase Price: $85 (with a 15% discount on a $100 stock).
2. Fair Market Value (FMV) at Purchase: $100.
3. Sale Price After Two Years: $150.

Without Adjusting Cost Basis:

• Reported Cost Basis: $85 (incorrect).
• Taxable Gain: $150 – $85 = $65.

With Adjusted Cost Basis:

• Adjusted Cost Basis: $100 (includes the $15 discount that was already taxed).
• Taxable Gain: $150 – $100 = $50.

By not adjusting the cost basis, the employee’s taxable income is overstated by $15, leading to higher taxes.

Common Pitfalls

1. Relying Solely on Tax Software:
   • Most tax software cannot automatically adjust the cost basis unless the employee manually inputs the correct figures.
2. Misunderstanding Tax Forms:
   • Employees often overlook the 3922 form or misunderstand its purpose, resulting in unadjusted cost basis reporting.
3. Lack of Education:
   • Many employees are unaware of the need to reconcile the cost basis between the 1099-B and the 3922 forms, leading to errors.

Best Practices for Employers

Employers can play a crucial role in ensuring employees understand and optimize their ESPP benefits:

1. Provide Clear Guidance:
   • Offer step-by-step instructions on how to adjust the cost basis using forms 1099-B and 3922.
2. Host Educational Sessions:
   • Conduct webinars or Q&A sessions on ESPP taxation and cost basis adjustments during tax season.
3. Use Visual Aids:
   • Share infographics or flowcharts to help employees understand the tax process, including holding periods and cost basis adjustments.
4. Leverage Technology:
   • Partner with equity administration platforms that simplify cost basis tracking and provide detailed reports for employees.

Empowering Employees

Accurate cost basis reporting ensures employees don’t overpay taxes and fully realize the benefits of their equity compensation. By providing education and resources, employers can:

• Reduce employee frustration during tax season.
• Enhance the perceived value of ESPP benefits.
• Build trust and engagement with their workforce.

Take Action

If you’re looking to improve your ESPP education initiatives or need guidance on best practices, Infinite Equity is here to help. Our team of experts specializes in equity compensation education and administration, ensuring your employees have the knowledge and tools they need to succeed.

Contact us today to learn how we can enhance your equity compensation program and provide your workforce with clarity and confidence.