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By Michael Gray

Ordinary income for "matured" ESPP shares based on grant date

It's "humble pie" eating time again.

Many people believe that, once you have met the holding period requirements for ESPP shares, the entire gain from selling the shares is long-term capital gain. (Like ISO shares, a taxpayer must hold the shares more than two years after the grant date and more than one year after the exercise date in order to make a qualified disposition.)

This is in error. When the option price for ESPP shares is discounted from fair market value (as virtually all of them are), some ordinary income must be reported when the shares are sold or on the final income tax return for the employee.

I reasoned that the amount to be reported as ordinary income would be the discount applicable to the taxpayer's purchase, but I was in error.

According to Internal Revenue Section 423(c), the ordinary income to be reported when there is a qualifying disposition or on a deceased employee's final income tax return is the lesser of (1) the excess of the fair market value of the share at the time of such disposition or death over the amount paid for the share under the option, or (2) the excess of the fair market value of the share at the time the options was granted over the option price.

(Remember, the limitation based on the excess of fair market value at disposition of the amount paid for the share under the option over the option price does not apply for a disqualifying disposition of ESPP shares.)

Some plans set an option price at the lesser of 85% of the fair market value on the grant date or the exercise date. When the option price is not fixed or determinable at the time the option is granted, then in determining the ordinary income to be reported, the option price is determined as if the option was exercised when granted.

Example 1. John Taxpayer purchased 100 shares of Supercorp stock under the company employee stock purchase plan on January 1, 20X1 for $8.50 per share. The fair market value of the shares on that date was $10.00 per share. The option for the ESPP shares was granted on June 30, 20X0 for an option price of $17.00 per share when the fair market value was $20.00 per share. John sold the Supercorp ESPP shares on July 31, 20X2 for $25.00 per share. For 2002, John will report ordinary income based on the excess of the fair market value over the option price of the shares on the grant date. $20.00 - $17.00 = $3.00/share X 100 shares = $300.00. The basis of the shares is increased for the ordinary income reported, so the basis for the shares is $8.50 per share + $3.00 per share = $11.50 per share. John will report a long-term capital gain of $25.00 - $11.50 = $13.50 per share X 100 shares = $1,350.00.

Example 2. Same facts as Example 1, except John sells the shares on July 31, 20X2 for $9.00 per share. Since the excess of the fair market value on the date of disposition over the option price paid ($9.00 - $8.50 = $ .50 per share X 100 shares = $50.00) is less than the excess of the fair market value of the shares over the option price on the grant date ($300, see above), the ordinary income is limited to $50.00. The tax basis of the shares is increased for the ordinary income reported. $8.50 + $ .50 = $9.00. John has a long-term capital gain of zero. ($9.00 - $9.00 = $0 per share X 100 shares = $0.)

You might have to ask the plan administrator for your employee stock purchase plan what the grant date was, and the option price and fair market value on that date.

So much for "common sense" in the tax laws.

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For an information package, send your name, company, address, email address, telephone number and fax number to Dawn Gray at info@stockoptionadvisors.com.

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Michael Gray regrets he can no longer answer emails personally. He will answer selected questions in this newsletter.

The answers to most questions can be found in our course, "Secrets of Tax Planning For Employee Stock Options". For details write Dawn Gray at info@stockoptionadvisors.com.

IRS Circular 230 Disclosure:

As required by U.S. Treasury Regulations, you are hereby advised that any written tax advice contained in this communication 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.

Consult with a tax advisor

For our readers who aren’t tax advisors, this newsletter is intended to alert you about tax issues that could affect you. It is not a substitute for advice from a professional tax advisor. You will find that getting advice from a qualified advisor is a worthwhile investment. We intend to eventually publish a directory of ESOAA members who are committed to helping clients with employee stock option issues.

Tax advisors should view the newsletter as an alert to become aware of issues relating to employee stock options for further research and study.

(Michael Gray is the co-author of Employee Stock Options – A Strategic Planning Guide for the 21st Century Optionaire. You can order the book at http://www.amazon.com or http://www.barnesandnoble.com/ or buy it at Stacey’s Books.)

P.S.

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