If the lower of the two numbers from Scenario 1 and 2 is negative, there is no ordinary income, only a capital loss.
If one or both of these conditions are unmet for Scenario 3, then the sale will be considered a disqualifying disposition. In this case, the amount included as ordinary income on your tax return is always equal to the FMV of stock on the purchase date minus the purchase price. In Scenario 3, this would mean that: Purchase Date FMV ($125) – Purchase Price ($85) = Ordinary Income ($40).
Stock sold at a price that is lower than the purchase date FMV does not decrease the amount of taxable ordinary income in a disqualifying disposition. Instead, you would receive a capital loss equal to the difference between the purchase date FMV and sale price.
Continuing with the Example
Still looking at the above example where the following information is known:
- ESPP Discount: 15%
- Offering Data FMV: $100
- Purchase Date FMV: $125
- Purchase Price: $85 (calculated from $100 x .85)
Purchase Date FMV ($125) – Purchase Price ($85) = Ordinary Income ($40)
Sale Price ($80) – Purchase Date FMV ($125) = Capital Gain/Loss (-$45)
This capital loss can be used to offset other capital gains in the current tax year and up to $3,000 of ordinary income, which means you may or may not be able to use the entire loss right away.
Determining How the Additional Gain or Loss of Your ESPP is Treated When It's Sold
If your ESPP stock is sold more than 12 months after the purchase date, any appreciation beyond the discount will be taxed as a long-term capital gain. Long-term capital gain tax rates are typically much lower than ordinary income tax rates, ranging from 0% to 20% federal, depending on your income.
If your ESPP stock is sold 12 months or less after the purchase date, any appreciation beyond the discount will be taxed as a short-term capital gain, subject to ordinary income tax rates ranging from 0% to 37% federal.
It is possible to receive long-term capital gain treatment in a disqualifying disposition if you sell ESPP stock more than 12 months after the purchase date but less than 18 months after the offering date. However, the amount of appreciation considered as a long-term capital gain will likely be less in a disqualifying disposition due to how the discount is calculated.
Regardless of how realized capital gains are characterized, it is important to note that you may also be subject to an additional 3.8% tax that applies to investment income above certain thresholds called the Net Investment Income Tax.
Selling ESPP stock after holding it for more than 18 months will often result in the most favorable tax treatment. However, it is important to remember that taxes should not be the only (or perhaps even primary) consideration in a decision to sell or hang onto shares of company stock. There are other factors at play including what the funds are being used for and how much company stock you currently own. Holding out for a qualifying disposition to save $1,000 in taxes would not be worth it if your ESPP shares lose $10,000 in value between now and then. This is especially important to consider when using your ESPP to fund short-term goals such as an emergency fund or a down payment on a home purchase.
