Qualified 423 Employee Stock Purchase Plans (“ESPPs”) have the potential to offer meaningful tax benefits to employees if they meet the qualified disposition rules. In practice, however, the rules around how to determine income tax versus capital gains for a qualified or disqualified disposition under these plans are among the most complicated tax rules in the world. Whether holding ESPP shares for a qualified disposition is worth it is highly dependent on the stock price path over the ESPP offering date, purchase date, and sale date.
Approximately 2/3 of participants are expected to hold their shares to meet the qualified holding period.1 Of course, every person’s tax situation is different, but generally, minimizing taxable income is a great benefit. However, it’s highly unlikely participants understand the intricacies of the taxable benefit they will receive under a qualified versus a disqualified disposition, and when it’s beneficial to keep holding versus selling. A lack of understanding and awareness of tax implications can result in unexpected taxes owed at year end or mistakes when filing taxes.
The Rules
Special rules under IRC 423 determine how much of the gain at sale is taxed as ordinary income and how much is taxed as capital gains. The tax rules are designed to encourage employees to hold shares longer by taxing more gain at lower long-term capital gains tax rates compared to ordinary income tax rates.
First, how long an employee holds shares before selling determines whether the sale is considered a qualified or disqualified disposition.
Next, apply the appropriate formulas for the type of disposition.
We will look at different outcomes that highlight the complexities of these rules:
- The advantage of a qualified disposition over a disqualified disposition may be modest, at the risk of an employee not adequately diversifying their investments out of company stock.
- In some cases, a disqualified disposition can actually result in a better tax scenario than a qualified disposition.
- If an employee sells at a loss, they will still recognize ordinary income under a disqualified disposition.
Consider a few different scenarios that illustrate the complexities of these rules:
- Price decreases resulting in a loss at sale employee still recognizes ordinary income for a disqualified disposition
- Modest increase in stock price where qualified disposition is still advantageous may not be significant enough gain to balance the risk of holding longer
- Stock price decreases during the offering period and then increases by the time of sale a disqualified disposition can result in a better tax outcome
We illustrate examples for the following scenarios:
| Scenario | Outcome |
|---|---|
| Significant Stock Price Appreciation from Offering Date through Post-Purchase | Qualified disposition yields significant savings |
| Stock Price Appreciation During Offering Period, Decline Post-Purchase | Qualified disposition is important to avoid paying more income tax than actual gain |
| Stock Price Decline During Offering Period and Post-Purchase | Qualified disposition is important to avoid paying income tax when there is no gain |
| Modest Stock Price Appreciation During Offering Period | Qualified disposition can result in lower taxes, but benefit isn’t material |
| Stock Price Decline During Offering Period, Recovery Post-Purchase | Disqualified disposition can result in lower taxes, but benefit isn’t material |
Significant Stock Price Appreciation from Offering Date through Post-Purchase Example
When the stock price increases significantly, a qualified disposition can be very beneficial to an employee. Consider an ESPP with a 15% discount and a look-back, a six-month offering period, and the following stock price pattern:
In this scenario, under a qualified disposition, an employee would pay about $2,000 in taxes. Under a disqualified disposition, depending on the timing, an employee would pay $2,500 or $3,000 in taxes, which is a 25% – 50% increase in the amount of taxes paid. This is a meaningful tax impact for scenarios where the price appreciates significantly.
Stock Price Appreciation During Offering Period, Decline Post-Purchase Example
When the stock price increases during the offering period but then decreases at sale, a disqualified disposition can result in recognizing ordinary income greater than the gain realized at sale.
Because the gain subject to ordinary income tax is based on the discount on the purchase date for a disqualified disposition, the employee recognizes ordinary income even greater than the actual value realized at sale. Further, because this scenario also results in a capital loss, holding the shares for less than a year to realize a greater short-term capital loss compared to a long-term capital loss is a better tax outcome. An employee would have to carefully track the stock price changes and timing of the sale to understand the implications of selling at different points in time.
Stock Price Decline During Offering Period and Post-Purchase Example
When the stock price decreases both during the offering period but then further at sale, employees should wait until the sale is qualified to avoid recognizing ordinary income when there is no actual gain.
It’s important in times when the stock price is declining that employees understand that selling ESPP shares at a loss in a disqualified disposition doesn’t take away the income tax component. It is very counterintuitive, and even feels punitive, so education is crucial. This type of unexpected tax outcome can leave employees feeling resentful and not wanting to participate in the program. If they wait to sell when it is a qualified disposition, they can avoid all income tax due and recognize a long-term capital loss.
Modest Stock Price Appreciation During Offering Period Example
When the stock price increases modestly, or is relatively flat, a qualified disposition will still result in lower taxes due, but the impact may not be as material to an employee. As such, employees may want to consider whether diversifying is the right strategy versus long-term holdings.
While the difference in selling within the first year after purchase versus waiting to sell in a qualified disposition is ~$100, that drops to ~$50 between 12 and 18 months after purchase (still a disqualified disposition). These amounts may not be very material, and employees may wish to invest their savings elsewhere rather than hold long term.
Stock Price Decline During Offering Period, Recovery Post-Purchase Example
When the stock price decreases during the offering period, and then subsequently increases at the time of sale, a disqualified disposition can result in lower taxes owed compared to a qualified disposition.
While sales between 12 and 18 months after purchase are disqualified dispositions, any capital gains tax due is long-term, rather than short-term, and taxed at favorable lower rates. This creates a unique scenario where sales in that window may be less than qualified dispositions, because there isn’t a significant difference in the portion taxed as income. While it is a modest savings of ~$80 (or 4% of taxes due), it still creates an additional complexity that is often not understood.
In Closing
ESPPs offer an incredible opportunity for all employees to become owners in their company. At the same time, companies don’t often provide adequate education resources—especially when it comes to taxes. The tax outcomes can vary significantly, and it’s unlikely employees are aware of the implications of selling their stock in a volatile or down market. If employees have an unexpected tax outcome after selling shares, it can lead to reduced participation, undervaluing the benefit, or misinformation if they don’t understand how the plan works.
Resources like annual tax trainings, videos focused on tax rules upon selling shares, and country-specific tax guides can create awareness and help employees avoid surprises. This type of general tax education does not cross the line into individual tax advice, so companies should feel confident providing these essential tools.
At Infinite Equity, we partner with companies to simplify the complexities of equity compensation—through clear communication, thoughtful education, and global-ready resources. Whether you’re looking to drive participation, reduce risk, or help employees make more informed decisions, contact Infinite Equity for help.
- Based on Fidelity’s analysis of ESPP client data and participant holding patterns. Holding rates vary across studies, so this figure should be viewed as an estimate. ↩︎
