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The public company I work for offers a stock purchase plan at a 15% discount. There is an annual limit to how much each employee can purchase at the discounted rate.

To keep things simple assume:

  • The stock price is $100/share, so it can be purchased through the plan at $85/share.
  • The stock price never changes
  • The stock will always be held for at least one year (no short term cap gains)
  • The max amount of stock that can be purchased annually is $5000 (based on the full price, not the discounted price)

Questions:

  • Does the discount amount count as income?
  • What is the actual rate of return?
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Beware that holding for one year may not be long enough to create a qualifying disposition. The sale also needs to be two years after the grant date. See this article. –  bstpierre May 11 '11 at 17:42

2 Answers 2

up vote 3 down vote accepted

Typically, the discount is taxable at sale time

But what about taxes?

When the company buys the shares for you, you do not owe any taxes. You are exercising your rights under the ESPP. You have bought some stock. So far so good.

When you sell the stock, the discount that you received when you bought the stock is generally considered additional compensation to you, so you have to pay taxes on it as regular income.

Source: Turbotax. Second source.

Your pretax rate of return would be: 17% (100/85)

In your scenario where the stock price is fixed at $100. Your tax rate would be your marginal rate. If the stock stayed at 100, you would still be taxed as income on $15/share (the discount) and would receive no benefit for holding the stock one year.

Assuming you are in the 25% tax bracket, your after tax rate of return would be 13% ((15*.75)+85)/85)

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Oddly, the discount gets taxes in the year the purchase is made. –  Phil Sandler May 27 '11 at 3:29

If your purchases are done at year end, but the money withheld over that 12 month period, the 17% return is for an average time of 6 months, and the return annualizes to 38% or so. All due respect to Alex B, the return would be 100/85 as he states, if the investment were funded in January and sold in December. But this isn't the case on ESPP, the average time you are out that money is 6 months.

I will warn you. Don't let the tax tail wag your investing dog. It's easy to wait for long term gains to kick in and then ignore the stock. You then find yourself overloaded on one stock and risk some bad losses. I enjoyed my 15% discount all the way to the stock crashing by 60%+. If you must wait and hold some, be religious about selling the long term shares like clockwork. The 15% is virtually risk free (unless the shares crash between purchase and hitting your account.)

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The 38% "annualized" may be true (in other words, you make 15% in 6 months, as you say it). However, after an actual year in the plan, you'll still have only 17% total gain - because you are forced to limit your contribution to the plan. –  NickC Jun 9 '11 at 5:11
    
@Renesis - if there are two six month periods, the 17% is experienced twice, and in fact, the 38% is the result. Say you earn $100k and can use 10% of your pay. The 10k over the year will grow to 13800. –  JoeTaxpayer Jun 9 '11 at 19:08
    
You're right. I don't know what I was thinking :) –  NickC Jun 10 '11 at 23:06
    
@Renesis - I might have said "since each 17% return is over a average 3 months they have your money, the compound growth rate is really closer to 87%" Then you'd say "come on Joe, it's not like you'd have $18700 from your $10000 after a year, the money is idle, earning pennies when it's not invested or not even earned." Then you were right, sir. ;) –  JoeTaxpayer Jun 11 '11 at 0:40

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