Do the tax consequences make it worth it for me to hold ESPP stock?

Question

Disclaimer — I've read What should I do with the stock from my Employee Stock Purchase Plan? and the answers seem to be both slightly wrong (from what I know) and contradictory, which is why I ask this question.

Last year I took a job with a public company for the first time. This company has two 6-month ESPP periods per year. The purchase price on the purchase date is 15% less than the lesser of the price on the first or last day. For the second period, the first date price carries through if it is the lesser.

The money used to purchase the shares is pulled from my income over those 6 months, with after-tax money.

Example (not real numbers):
6 months of contributions to ESPP: $3000
Stock price on first day (grant date): $20
Stock price on last day: $25
Purchase price: $20 * 0.85 = $17
Shares purchased: 176
Share market value on purchase date: $4400 (47% gain)

In this scenario, I made nearly 50% gain if I sell the stock immediately. This is what I'd like to do, since I see no reason to heavily weight my portfolio with a single stock.

However, from what I understand, I must hold onto my stock for 18 months (at least one year from the purchase date and two years from the grant date) for this not to count as compensation income for tax purposes.

My questions are

1. If I only sell a portion of the stock (say, $3000 worth), is the "compensation income" counted proportionally (approximately 32% of it would be added to my tax liability), or is it counted against the after-tax money I put into the stock? (liability being cash-out minus contribution, nothing in this case)

2. The accepted answer says that "it's advantageous to hold for one year" but also "I sell out early". I understand that at least in my case, it's actually 18 months, but regardless, those two statements sound like contradictions. Anything could happen in that time. So which one is really advantageous?

3. Lastly am I understanding this correctly that at the worst case, it will just treat the gain as additional income, and not additional income and capital gains (double taxation?)

Answer 1

To try to answer the three explicit questions:

1. Every share of stock is treated proportionately: each share is assigned the same dollar amount of investment (1/176th part of the contribution in the example), and has the same discount amount (15% of $20 or $25, depending on when you sell, usually). So if you immediately sell 120 shares at $25, you have taxable income on the gain for those shares (120*($25-$17)).

2. Either selling immediately or holding for the long term period (12-18 mo) can be advantageous, just in different ways.

   Selling immediately avoids a risk of a decline in the price of the stock, and allows you to invest elsewhere and earn income on the proceeds for the next 12-18 months that you would not otherwise have had. The downside is that all of your gain ($25-$17 per share) is taxed as ordinary income.

   Holding for the full period is advantageous in that only the discount (15% of $20 or $25) will be taxed as ordinary income and the rest of the gain (sell price minus $20 or $25) will be taxed at long-term capital gain tax rates, which generally are lower than ordinary rates (all taxes are due in the year you do sell). The catch is you will sell at different price, higher or lower, and thus have a risk of loss (or gain).

3. You will never be (Federally) double taxed in any scenario. The $3000 you put in will not be taxed after all is sold, as it is a return of your capital investment. All money you receive in excess of the $3000 will be taxed, in all scenarios, just potentially at different rates, ordinary or capital gain. (All this ignores AMT considerations, which you likely are not subject to.)

Answer 2

I think people in general tend to unnecessarily over-complicate this issue. Here's what I think you should do in any situation like this: First and foremost, put all tax considerations aside and decide whether it makes sense to sell the stock now or hold on to it for the long term based on its merits as an investment. Tax considerations have absolutely nothing to do with whether the stock is a good investment. If you consider all non-tax factors and decide to hold on to it for the long term, then you can use the tax considerations as a very minor input to how long you should hold it - in other words, don't set your time horizon to 17.5 months if waiting another 2 weeks gives you better tax treatment.

You're going to pay taxes on your gains no matter what. The only difference is whether you pay capital gains tax or income tax. Granted, the income tax rate is higher, but wouldn't it suck if you pay a LOT less tax only because you have a LOT less value in your stock?

So to answer your question - I would say, absolutely not, tax consequences do not make it worthwhile to hold on to your ESPP shares. If you decide to hold on to your ESPP for other reasons (and they better be good ones to put that much free profit at risk), only then should you look at the tax consequences to help fine-tune your strategy.

Answer 3

Your gain is $1408. The difference between 32% of your gain and 15% of your gain is $236.36 or $1.60 per share. If you sell now, you have $3957.44 after taxes.

Forget about the ESPP for a moment. Are you be willing to wager $4000 on the proposition that your company's stock price won't go down more than $1.60 or so over the next 18 months? I've never felt it was worth it.

Also, I never thought it made much sense to own any of my employer's stock. If their business does poorly, I'd prefer not to have both my job and my money at risk.

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If you sell now:

Gain:
  ($25/share mkt value - $17/share you paid) * 176 shares = $1408.00

Less taxes:
  $1408.00 * (1 - 0.32) = 957.44

Plus the original after-tax contribution:
  $957.44 + $3000.00 = 3957.44

Now assuming you hold for 18 months, pay 15% capital gains tax, and the stock price drops by $1.60 to $23.40:

Gain:
  ($23.40/share mkt value - $17/share you paid) * 176 shares = $1126.40

Less taxes:
  $1126.40 * (1 - 0.15) = 957.44

Plus the original after-tax contribution:
  $957.44 + $3000.00 = 3957.44