An employee stock purchase plan lets employees buy company stock at a discount - typically 5% to 15% below market price, with some plans offering a "lookback" feature that applies the discount to the lower of the price at the start or end of the offering period. For a qualified §423 ESPP, the tax treatment is favorable if the employee holds the stock long enough: the discount becomes ordinary income only when the stock is sold, and only at the lower of the discount at grant or the actual gain. Sell too soon and the entire discount - and potentially more - becomes ordinary income on your W-2. Most employees receive no guidance on ESPP tax mechanics and pay more tax than necessary by making avoidable mistakes.
Qualifying disposition (favorable): The stock is sold more than 2 years after the offering date AND more than 1 year after the purchase date. Both conditions must be met. When both are met: ordinary income equals the lesser of (a) the actual gain on the sale or (b) the discount at the beginning of the offering period. All remaining gain is long-term capital gain.
Disqualifying disposition (less favorable): The stock is sold before either the 2-year or 1-year period expires. Ordinary income equals the full spread between the purchase price and the FMV on the purchase date (the entire discount at the time of purchase), regardless of what the stock is worth at sale. The ordinary income is included in W-2 Box 1 even though the employer may not withhold on it.
After a disqualifying disposition, the employer reports ordinary income on Form W-2 equal to the discount at purchase. The employee's cost basis in the stock for capital gain purposes is the purchase price PLUS the ordinary income recognized. Without this basis adjustment, the employee would pay tax twice - once as ordinary income on the W-2 and again as capital gain on the full proceeds minus the discounted purchase price.
To receive favorable §423 treatment, the ESPP must meet several requirements: it must be approved by shareholders; all employees of the sponsoring employer must be eligible (with limited exceptions for very new employees and highly compensated employees); the maximum discount cannot exceed 15%; no employee may purchase more than $25,000 of stock (measured by FMV at the offering date) per year; and no employee owning 5% or more of voting power may participate. Plans that do not meet these requirements are nonqualified ESPPs where the discount is always ordinary income at the time of purchase.
A nonqualified ESPP does not meet §423 requirements. When stock is purchased under a nonqualified ESPP, the discount is immediately ordinary income on the purchase date - regardless of when the stock is sold. The income appears on Form W-2 (or Form 1099-MISC for non-employees). The employee's basis equals the FMV at purchase. Any subsequent gain or loss is capital, with the holding period beginning on the purchase date. There is no advantage to holding nonqualified ESPP shares past any particular holding period for income tax purposes.