What do baseball and tax season have in common? Both return in March and errors can be painful. The potential for confusion and mistakes on tax returns looms especially large when you have shares acquired from an employee stock purchase plan (ESPP), whose basic taxation is already confusing enough.
ESPP reporting even confuses experienced accountants, financial advisors, and enrolled agents. Understanding the important issues will help you avoid overpaying your taxes or drawing unwanted attention from IRS auditors.
Below are six big reporting mistakes to avoid when you have ESPP compensation income or sell shares acquired from purchases under your plan. Some of these also apply when you have stock options or restricted stock units. The benefits of ESPPs are worth the tax complexity: ESPPs can be very valuable for employees, as I explain in a prior Forbes.com article.
1. Paying tax too early on the discount. While there are various types and designs for ESPPs, a tax-qualified ESPP under Section 423 of the Internal Revenue Code lets you buy company shares through after-tax payroll deductions at a discount of up to 15%. When this type of ESPP is involved, you should not include the discount as part of your taxable income for the year of purchase unless you also sold the shares in the same year.
When you don’t satisfy the ESPP holding periods (more than two years from enrollment and one year from purchase), you have compensation income in the year of sale equal to the spread at purchase, i.e. the difference between the fair market value of the stock on the purchase date and the discounted price you actually paid for it.
Example: Your company offers a 15% discount with a lookback that calculates it on the lower of the stock price at the offering start or on the purchase date.
- Market price: $50 at the start of the offering and $55 on the purchase date
- Purchase price: $42.50 (85% of $50)
For ESPPs that are not tax-qualified under IRC Section 423, the taxation is similar to that of nonqualified stock options (NQSOs). The purchase income for this type of ESPP is reported and appears on your Form W-2 for the year of purchase, regardless of whether you sell the stock, and the same reporting issues for NQSOs apply after you sell the shares.
2. Not filing Form 8949 after an immediate sale of ESPP shares at purchase. With an immediate sale of your ESPP shares at purchase, the discount is reported on your W-2 and on your tax return as ordinary income. Even though you never held the stock (or at least not for long) after purchase, you still need to report this sale transaction on Form 8949 and Schedule D, which are used to report capital gains and losses on all stock sales.
You may even have some small gains or losses, depending on how your company calculates the discount at purchase, how long it takes for the shares to become available in your account, and any commissions and fees for the stock sale.
Alert: If the IRS were to receive a report of your sale proceeds from your broker (on Form 1099-B) but without a corresponding report of the sale on your Form 8949, it would think you had failed to report the gain on the sale. Assuming a tax basis of $0, the IRS computers would then automatically send you a CP2000 notice for taxes due on the full amount of the sale proceeds.
3. Directly using what appears as the cost basis on your Form 1099-B. Under IRS rules, the Form 1099-B issued to you by your broker cannot report the compensation element as part of your cost basis. Only the purchase price will appear, and the basis does not need to be included for stock that was purchased before 2011. This means you must check the accuracy of the basis and make any necessary adjustments on Form 8949.
Alert: When compensation income is not part of the tax basis reported in Box 1e on Form 1099-B, make a gain or loss adjustment in column (g) of Form 8949, and enter code B in column (f), among other steps. Should Box 1e be blank, report the full basis in column (e).
See the section Reporting Company Stock Sales on the website myStockOptions.com for annotated diagrams of Form 8949 that show the proper tax-return reporting for sales of shares acquired from ESPPs, stock options, and restricted stock units.
4. Paying the wrong tax on the discount. The full ESPP purchase discount doesn’t qualify for capital gains treatment even when you have held your stock for more than one year after the date of purchase, and for more than two years after the beginning of the offering period. With a tax-qualified (Section 423) ESPP, you’ll still have ordinary income in the year of sale equal to the lesser of either the actual gain upon sale or the purchase price discount at the beginning of the offering. But beyond the discount, all additional gain is treated as long-term capital gain.
5. Using the wrong price when there is no lookback. If your company’s ESPP does not have a lookback feature, the actual discount for the stock purchase and for tax purposes will often differ with a qualifying disposition that provides the best tax treatment, adding to the potential for tax-return mistakes. Even with an ESPP that has no lookback, the purchase price discount for calculating the ordinary income for the taxes is still computed from the price on the first day of the offering period and not on the purchase date.
6. Paying tax twice on the discount. With ESPPs, the purchase discount for tax purposes is reported to the IRS on Form W-2 and is included in your income in the year of sale. Thus, when you sell the shares, do not make the purchase price your cost basis without following other steps when you complete Form 8949 to report the sale. Avoid double taxation on the discount by understanding what the cost basis on your 1099-B includes, why it may be wrong, and how to make an adjustment on that IRS form (see #3 above).
You will also mistakenly double-report income if you do not realize that your W-2 income in Box 1 already includes stock compensation income. What your company may have voluntarily reported in Box 14 of Form W-2 does not change the Form 1040 reporting. You may wrongly think it was left out of Box 1 because there is no tax withholding or employment tax (i.e. Social Security and Medicare) on a tax-qualified ESPP, and then erroneously report the income as “Other income” on Schedule 1.
Doing that would cause the income to be taxed twice as ordinary income, as it was already included in the W-2 income reported on Line 1 of Form 1040.
For more guidance on tax returns that involve stock compensation, whether stock options, restricted stock units, employee stock purchase plans, or performance shares, see the articles, FAQs, and annotated diagrams of IRS forms in the Tax Center at myStockOptions.com. Just for fun, try the tax-return quiz to test your knowledge.