How an ESPP works
A qualified (Section 423) ESPP lets you set aside payroll money to buy company stock at a discount, usually up to 15%. Many plans add 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 — which can make your effective discount far larger than 15% when the stock has risen.
The discount is always partly ordinary income
The discount is valuable but never fully tax-free. Some of your gain is always taxed as ordinary income and the rest as a capital gain. The split depends entirely on whether your sale is a qualifying or disqualifying disposition — the most important decision you make with ESPP shares.
Qualifying vs disqualifying disposition
A qualifying disposition requires holding the shares more than two years from the offering date and more than one year from the purchase date. Meet both and the ordinary-income portion is limited to the lesser of your actual gain or the discount measured at the offering price, with the rest taxed at 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
Like RSUs, ESPP shares are often double-taxed by accident. Your broker's 1099-B usually shows only the discounted price you paid, not the amount already taxed as ordinary income. If you file it unchanged, you pay tax on the discount twice. Adjust the basis upward on Form 8949 to include the ordinary-income component; Form 3922 from your employer has the dates and prices you need.
Is an ESPP worth it?
For most people, yes — clearly. A 15% discount with a lookback is a large, near-guaranteed return that the tax never turns negative if you sell at or above your purchase price. The only real risks are tying up too much money in one stock and holding a concentrated position for the tax benefit when diversifying would be wiser. Many participants buy at each purchase and sell soon after to lock in the discount.
A quick example
Offering price $40, purchase price $50, 15% discount with lookback. You buy at 15% off the lower price: $40 × 0.85 = $34. For 100 shares your cost is $3,400. Sell at $60 ($6,000). In a qualifying disposition the ordinary income is the lesser of your $2,600 gain or the $600 offering-date discount — so $600 is ordinary income and $2,000 is long-term gain. In a disqualifying sale the ordinary income is the full $1,600 discount at purchase, with $1,000 as a capital gain.