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Subject:   ESPP question
Date:   Fri, 27 Jan 2006
From:   Anonymous

Suppose I enroll in an ESPP. I purchase shares at $8.50 per share (85% of the lesser of the market price on the subscription date or the exercise date). The fair market value on the exercise date was $25.

I sell the shares within a year for $18 per share. Do I report ordinary income of $25 - $8.50 = $16.50 per share, and a capital loss of $18 - $25 = ($7) per share?

I would like to quickly sell ESPP shares for a $15 turnaround profit, but have older shares that must be sold first.

How does the situation change after I hold the shares after meeting the holding period requirements (more than two years after grant, more than one year after exercise)?

Answer

Date:   Wed, 08 Feb 2006

Hello,

We have a report on our web site that explains this situation at stockoptionadvisors.com/espps-isos.shtml.

You are correct about the consequences when you sell ESPP shares before meeting the holding period requirements. There is no "escape hatch" in that situation like for ISOs.

There is an exception to the ordering rules for securities sales, called specific identification. It seems to me that if you make a simultaneous exercise and sale, the transaction should qualify because your intent is clear. It's even better to state your intention in writing when you are giving instructions for the transaction.

When you meet the holding period requirements for ESPP shares, you report ordinary income for the 15% discount based on the grant/subscription date value. The ordinary income is limited to the excess of the selling price over the option price. The fair market value on the exercise date is no longer a concern. Using your figures, the ordinary income would be $10 ($8.50/85%) - $8.50 = $1.50 per share. The long-term capital gain would be $18 - ($8.50 + $1.50) = $8 per share.

Good luck!

Mike Gray

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IRS Circular 230 Disclosure: As required by U.S. Treasury Regulations, you are hereby advised that any written tax advice contained in this answer was not written or intended to be used (and cannot be used) by any taxpayer for the purpose of avoiding penalties that may be imposed under the U.S. Internal Revenue Code.