An Employee Stock Purchase Plan (ESPP) is a tax-advantaged program governed by IRC ยง423 that allows employees to purchase company stock at a discount using after-tax payroll deductions. Deductions accumulate over an offering period (typically 6 months) and are used to purchase shares at a discount of up to 15% of the FMV. Many plans feature a lookback provision (a rule that bases the purchase discount on the lower of the stock price at the start of the offering period or the purchase date).
The tax treatment of ESPP shares is determined by the holding period.
Qualifying Disposition. To qualify for preferential tax treatment, you must hold the shares for at least two years from the start of the offering period and one year from the purchase date. Upon sale, the discount portion (the difference between the actual purchase price and the FMV at the start of the offering period) is taxed as ordinary income. The remaining profit is taxed as long-term capital gain.
Disqualifying Disposition. If the shares are sold before meeting both holding periods, the sale is a disqualifying disposition. The difference between the FMV on the purchase date and the purchase price is taxed as ordinary income in the year of sale, regardless of the sale price. Any subsequent gain or loss is treated as capital gains. If the stock price declines below the purchase-date FMV before sale, the taxpayer must still report the full purchase-date spread as ordinary income, while claiming a capital loss on the sale.