How an ESPP is taxed
An Employee Stock Purchase Plan lets you buy company stock at a discount, usually 15%, often with a lookback that applies the discount to the lower of the price at the start of the offering period or the price on the purchase date. That discount is valuable — but it is never tax-free. Part of it is taxed as ordinary income and part as a capital gain, and the mix depends on how long you hold the shares.
Qualifying vs disqualifying disposition
The single most important choice with ESPP shares is when you sell. A qualifying disposition requires holding the shares more than two years from the offering date and more than one year from the purchase date. If you meet both tests, the amount taxed as ordinary income is limited to the lesser of your actual gain or the discount measured at the offering-date price, and the remaining gain is taxed at preferential long-term rates. A disqualifying disposition — selling before either test is met — taxes the full discount at purchase as ordinary income, with any further gain as a capital gain.
The cost-basis trap
Just like RSUs, ESPP shares are frequently double-taxed by accident. Your broker's 1099-B often shows only the discounted price you paid. But the amount already taxed as ordinary income is part of your real cost basis. If you file the broker's number unchanged, you pay income tax on the discount and then capital-gains tax on the same dollars. On Form 8949 you adjust the basis upward to include the ordinary-income component. Form 3922, which your employer issues, contains the dates and prices you need.
A quick example
Suppose the offering-start price was $40, the purchase-date price was $50, and your plan gives a 15% discount with a lookback. You buy at 15% off the lower price: $40 × 0.85 = $34 per share. For 100 shares your cost is $3,400. You later sell at $60 ($6,000). In a qualifying disposition, the ordinary income is the lesser of your $2,600 gain or the offering-date discount of $40 × 15% × 100 = $600 — so $600 is ordinary income and $2,000 is long-term capital gain. In a disqualifying sale, the ordinary income is the full discount at purchase, ($50 − $34) × 100 = $1,600, and the remaining $1,000 is a capital gain.
Final word
ESPPs are one of the best deals in employee compensation, and the tax rarely makes them a bad idea. What the tax does decide is how much of the discount you keep — so hold to a qualifying disposition when you can, and always correct your cost basis so you are never taxed twice. When the amounts are large, confirm with a qualified tax professional.