Detailed Breakdown of an ESPP Qualifying Disposition
Purchasing stock through an Employee Stock Purchase Plan (ESPP) is one of the best ways to quickly accumulate shares in the company you work for. It’s also an easy source of funds to pull from to purchase a house, add to an emergency fund, or add to your investment portfolio.
One thing that makes ESPPs a little different is that when you ultimately sell your shares, there are two types of dispositions. The first is called a Qualifying Disposition and the second is called a Disqualifying Disposition.
The purpose of this article is to explain the ins and outs of Qualifying Dispositions (sometimes also known as Qualified Dispositions). We’ve also written an article addressing ESPP Disqualifying Dispositions, but given that each disposition is pretty complex, it’s best to discuss each separately.
Why Would You Want a Qualifying Disposition?
As it is with so many financial decisions, one of the reasons you’d want a qualifying disposition when you sell ESPP shares is to save money on taxes.
When you ultimately sell your ESPP shares, the hope is that you’ll have a fairly substantial gain. And to save money on taxes from that gain, you’ll want as much as possible of it to be treated as a long-term capital gain rather than ordinary income.
Long-term capital gains tax rates are applied to assets that you hold for over a year. Ordinary income tax rates are applied to your salary, bonuses, and assets that you hold for less than a year.
When comparing these rates, you’ll see that long-term capital gains rates can be quite a bit lower than ordinary income tax rates.
As you compare the two rates, please note that we’ve excluded some additional taxes you are likely to owe once you bump up into higher tax brackets (e.g., Medicare surtax, additional Medicare taxes on salary, or state income taxes). Here are links to NerdWallet’s brackets for both ordinary income and capital gains if you want to review where these percentages are coming from.
As you can see from the comparison of tax rates, long-term capital gains rates can be anywhere from 7% to 20% cheaper than ordinary income tax rates. So the idea is that when you sell your ESPP shares, it’s best to have more of the gain fall under the long-term capital gains rates.
People often assume ESPP Qualifying Dispositions will yield the best tax result, but this isn’t always the case. We’ll explain why here in a second.
Requirements for an ESPP Qualifying Disposition
An ESPP Qualifying Disposition is defined as a sale of ESPP shares that meet the following requirements:
2+ years have passed since the beginning of the offering period in which you purchased shares
1+ year has passed since the purchase date of the shares
We’ve included the following illustration to help.
The most common offering period for an ESPP is 6 months, so any time you make a purchase through your ESPP, you would really only need to wait a year and a half for your sale to be considered a Qualifying Disposition.
If your company offers an even longer offering period, it’s entirely possible that you’d only need to wait one year for a Qualifying Disposition (which is yet another benefit of long offering periods).
Determining Taxes on an ESPP Qualifying Disposition
With any disposition of ESPP shares there’s going to be a portion of your gains that will be taxed at ordinary income tax rates and another portion that will be subject to capital gains tax rates (either short-term or long-term).
Because this is the case, in order to determine the taxes on an ESPP Qualifying Disposition, you will need to calculate which portion of your gains are to be taxed as ordinary income and which portion of your gains are to be taxed as long-term gains. The next two sections of this article will show you how to make these calculations.
Ordinary Income Portion of an ESPP Qualifying Disposition
To calculate the ordinary income portion of your Qualifying Disposition, you’ll need to look at the lesser of the following:
The gain or loss you realize from selling shares.
(Calculated by taking your sales price minus your discounted purchase price)
The ESPP discount applied to the share price at the beginning of the offering period.
You can run this calculation with totals or you can do it per share. We usually find it easier to do on a per share basis since the numbers are smaller.
To illustrate how this works, let’s use the hypothetical example of an imaginary company called “Cool ESPP.” (We apologize in advance if this reads like a math exam problem or something. It’s not, so just humor us here.)
Cool ESPP offers a 15% discount, has 6-month offering and purchase periods, and offers a look-back.
At the beginning of the offering period, Cool ESPP was trading for $60 a share. At the end of the purchase period, Cool ESPP was trading for $75.
You decide that you want to hang onto your Cool ESPP shares long-term and wait for a Qualifying Disposition. A year and half after your original purchase, Cool ESPP is trading for $80 and you decide to sell everything you originally purchased.
So now the question is, how much of your gain will be subject to tax as ordinary income?
Take the lesser of:
Your gain, which is $80 minus $51 = $29 per share
(Remember, you received a 15% discount on the offering period price.)
The discount applied to the offering period price, which is $60 * 15% = $9 per share
Since $9 per share is the lesser number, you’ll have $9 of ordinary income for every share that you purchased and sold from this batch of ESPP shares.
Capital Gains Portion of an ESPP Qualifying Disposition
Calculating the capital gains portion of a Qualifying Disposition is much easier than calculating the ordinary income portion, but you’ll still need to do both.
Normally, calculating capital gains is as easy as taking what you sold for minus what you paid, but since on your Qualifying Disposition there’s a portion that’s being taxed at ordinary income rates, you need to remove that portion from your calculation or you could end up paying extra taxes (and nobody wants that!).
Continuing on from the example above, we sold our Cool ESPP shares for $80 per share and purchased them for $51 per share.
The total gain from the transaction was $29 per share, but the ordinary income component was $9 per share. So the capital gains portion of our qualifying disposition will be $20 per share.
Example of Price Going Down Then Up On a Qualifying Disposition
In the examples above, we show the tax effects of a Qualifying Disposition if the share price only goes up, but what happens if the price at the end of the purchase period is lower than the price at the beginning of the offering period?
To illustrate what this would look like, here’s a modification of our Cool ESPP example:
Cool ESPP started the offering period at $60 per share. At the end of the purchase period, Cool ESPP was trading for $45 per share. After waiting the full time for a qualifying disposition, Cool ESPP has risen all the way to $80 per share and this is when you decide to sell.
Just as the first example, we need to determine the ordinary income portion of the Qualifying Disposition first.
Take the lesser of:
Your gain, which is $80 minus $38.25 = $41.75 per share
(Remember, you received a 15% discount on the purchase period price this time because the price had gone down.)
The discount applied to the offering period price, which is $60 * 15% = $9 per share
Since $9 per share is the lesser number, that is going to be your ordinary income per share.
The big thing to note here is that even though you use the ending purchase period price to determine your actual cost per share, the calculation for Qualifying Dispositions still looks at the discount applied to the beginning of the offering period!
So even though the 15% discount resulted in a $6.75 discount, you’ll actually have more ordinary income per share than that discount.
This is important to remember because it makes waiting for a Qualifying Disposition less worthwhile and may tip the scale in favor of doing a Disqualifying Disposition instead.
When Do You Want a Qualifying Disposition of Your ESPP Shares?
Determining if you want to wait for a Qualifying Disposition depends on a variety of factors. (Which is why, at some point, we plan to write an entire article devoted to this topic as follow-up to this one.)
For many people, it makes sense to sell ESPP shares immediately/shortly after purchase to ensure that you lock-in the gain from the discount (even if it means paying a little more in taxes). But if that’s not you, here are a few reasons why you might want to wait for a Qualifying Disposition.
You don’t need cash immediately from your ESPP and are investing pretty heavily in a diversified way outside of your ESPP. A year or a year and a half may not seem like a long time to wait for a Qualifying Disposition, but as we’ve seen in 2022, even two to three months can bring a substantial downturn in the stock market.
The stock price has gone up significantly from the beginning of the offering period. If you’re purchasing stock for a massive discount compared to what it’s currently trading for, it could be worth waiting for long-term capital gains.
You sell all your Restricted Stock Units (RSUs) at vest and want to replace the holding with your ESPP holdings. Because of the discount ESPPs provide, it’s a great way to accumulate shares of a company you believe in long-term.
When Would You Not Want a Qualifying Disposition?
We’ve covered this topic extensively in our “When Should You Sell ESPP Shares” article, so we encourage you to review that information there. That said, here are two major reasons why you might not want a Qualifying Disposition.
You need cash now. If you’re needing cash pretty regularly, it makes sense to participate in your ESPP with the plan of not waiting for a Qualifying Disposition.
Your company’s stock price is volatile or you’re pessimistic about the company. Waiting for a Qualifying Disposition can result in selling your ESPP shares for less than what you purchased them for. It’s hard to predict with 100% accuracy (impossible, actually) where a company’s stock price will go, so please don’t wait for a Qualifying Disposition if you can’t afford the risk.
Final Thoughts on ESPP Qualifying Dispositions
The tax benefit of doing a Qualifying Disposition usually does not outweigh the risk that your company’s stock could go down while you wait. We built an ESPP Gain and Tax Calculator to help illustrate the gain/cost differences and you may be surprised at how little Qualifying Dispositions help. The only time it makes a truly significant difference is when a company’s stock price goes up substantially (which we discussed previously).
If you plan to hold on to your company’s stock, please be sure that your rationale for doing so is solid and that your personal finances are in good order.
We’re happy to help you think through these decisions and to be a resource for you.
As always, thanks for reading.