When you consider year-end planning, don't forget to review ESPP shares you may hold. Below we outline issues and strategies to think about. Of course, each scenario and its strategy will vary according to your own circumstances and the outlook for your company's stock price. The end of the year can also be a time to decide about ESPP enrollment in the new year and the amount of your salary to contribute for share purchases.
The end of the year can be a good time to decide about ESPP enrollment in the new year and the amount of your salary to contribute for share purchases.
Unless you were already intending to sell company stock soon, a sense of unease about your future tax rates should not, in the view of many experts, be the only reason for selling at the end of the year. However, you want to do multi-year projections for your income while being aware of the trigger points for:
- higher tax rates on ordinary income, capital gains, and dividends
- the Medicare surtax
- phaseouts for personal exemptions and itemized deductions
Changes In Medicare Tax
The Medicare tax rate on compensation income (normally 1.45%) is 2.35% for single taxpayers with yearly earned income of more than $200,000 and for joint filers with yearly earned income of more than $250,000. (Remember that Social Security and Medicare taxes apply only to income from ESPPs that are not tax-qualified.) In addition, a 3.8% Medicare surtax now applies to investment income, such as dividends and stock-sale proceeds, for people in this range of adjusted gross income.
Alert: If your income will trigger the Medicare surtax next year and you have company stock from an ESPP purchase that you intend to sell soon, you may want to evaluate whether to do this in 2015 rather than in 2016 to avoid the additional 3.8% tax.
If You Purchased ESPP Shares This Year
Once you have enrolled in your ESPP, it's important to follow your company's stock price in relation to your purchase price. As explained in the next section, the tax treatment (i.e. ordinary income vs. capital gains/losses) can vary depending on when you sell the ESPP shares and how that sales price compares to your purchase price. If you did not quickly sell the shares immediately after purchase, which would result in taxes at your ordinary income rate on any purchase discount, most strategies involve determining how long to hold the shares after purchasing them through tax-qualified ESPPs. (These are sometimes called Section 423 ESPPs after the part of the Internal Revenue Code that governs them.)
However, with an ESPP that is not tax-qualified, the tax treatment is fixed at the time of purchase and the spread at purchase is taxed just like the exercise spread of nonqualified stock options. This is the tax rule for your federal and state income tax, regardless of the future stock price and whether you hold or sell the stock.
Once you have enrolled in your ESPP, it's important to follow your company's stock price in relation to your purchase price.
Your Company's Stock Price Dropped After Your Purchase This Year
You may have planned to sell your shares at price targets after holding them long enough to receive long-term capital gains treatment and avoid a disqualifying disposition (this occurs when you sell within one year of purchase and two years of the grant date). However, if the stock price fell after the purchase, you may want to consider selling the stock to receive a short-term capital loss. You may be able to net the loss against any capital gain from stocks you sold after the market recovered. Alternatively, you may want to diversify, or at least put aside the funds to cover any additional taxes that you expect to owe with your tax return. You need to remember that your early sale will also trigger ordinary income on the discount at purchase.
Alert: When you sell company stock at a loss, be careful about the wash sale rules if you intend to buy company stock again soon, as with an ESPP purchase or the reinvestment of an ESPP dividend in stock. Wait at least 30 days. However, be aware that the wash sale rule applies only after sales of company stock for a loss. You can sell appreciated stock for a gain and quickly repurchase it without wash sale problems.
The Stock Price Rose After Your Purchase
Alternatively, your stock price may have substantially increased, hitting your targets earlier than you expected. Now you may want to sell before the one-year mark because you are concerned that your stock has peaked or that tax rates may rise, or because you are worried about overconcentration in company stock. However, you may not want to pay short-term capital gains rates (i.e. the same rates as those for ordinary income). Plus, you'll still have ordinary income on the spread at purchase. Check whether you have capital-loss carry-forwards from last year or short-term losses from earlier this year that you can net against these gains. This is a good time to use losses astutely harvested during the market downturn.
Check whether you have capital-loss carry-forwards from last year or short-term losses from earlier this year that you can net against gains.
Alert: The fact that you held the ESPP stock for more than one year does not mean you automatically get the favorable tax treatment of tax-qualified ESPPs. You also must be sure you hold the stock until at least two years have elapsed since the start of the ESPP offering. You can still have long-term capital gain or loss for the stock sale and an ESPP disqualifying disposition if you do not hold the ESPP stock two years from when the offering began (i.e. the grant date).
ESPP taxation can be confusing. It becomes even more so when you are trying to make decisions about stock from an ESPP purchase earlier in the year or more than one year ago. When you satisfy the holding-period requirements for tax-qualified ESPPs (i.e. you hold the shares for over two years from grant and one year from purchase), you still have ordinary income for the portion of the gain equal to your company's discount (e.g. 5%, 10%, or 15%) from the offering/start price, regardless of the actual purchase price for the stock, and even if there is no lookback.
With a tax-qualified ESPP, the breakdown of ordinary income and capital gains can vary according to a number of factors. This sometimes creates tax oddities.
Ordinary income is either that discount spread or the actual gain at sale, whichever is lower. When stock is sold at a loss, you have no ordinary income, just a capital loss. However, when you sell the stock early in a disqualifying disposition (e.g. for an ESPP purchase in 2015), the spread at purchase is ordinary income, regardless of the sales price. With this early sale, you will have ordinary income even though you have no actual gain because the stock price dropped.
With a tax-qualified ESPP, the breakdown of ordinary income and capital gains can vary depending on when you sell the stock and its price, and on which ESPP shares you sell. This can create tax oddities.
Alert: When you sell company stock that is from an ESPP, it's important to identify which lot (i.e. shares from which purchase date) you are selling.
These examples show how the tax treatments differ according to the price at the time of sale in relation to the price when you purchased it:
Example (up market): The company uses a 15% discount, and the stock price is $10 per share on the first day of the offering period, $12 on the last day of the offering period, and $14 when you sell. You will recognize ordinary income of $3.50 per share ($12 minus your purchase price of $8.50) and short-term capital gain of $2 per share ($14 minus your $12 tax basis, which is the sum of your purchase price and the amount of ordinary income you recognized) when you sell the stock.
Example (down market): Regardless of the actual sale price of the stock, you will recognize ordinary income from the discount of the market price on the purchase date. The stock price declines to $9 per share between the purchase date and the day you sell. You will still recognize ordinary income of $3.50 per share ($12 – $8.50), and you will have a capital loss of $3 per share ($9 sale price minus your $12 basis in the stock). If the stock price declines to $7 per share between the purchase date and the day you sell (more than one year from purchase but less than two years from the offering's start), you will still also recognize ordinary income of $3.50 per share and a long-term capital loss of $5 per share. When you do not have other capital gains to immediately use up these losses, your tax payment can exceed any profits in the year of sale.
When the market price on the purchase date (e.g. $10) is lower than the market price on the offering date (e.g. $12), you will, oddly enough, recognize less ordinary income in a disqualifying disposition (e.g. $10 purchase date market price – [$10 x 0.85 = $8.50] = $1.50 in ordinary income) than in a sale that meets the holding-period requirements (e.g. $12 grant date market price – [$12 x 0.85 = $10.20] = $1.80 in ordinary income). Since it is usually better to have capital gains than ordinary income, as capital gains can be netted against capital losses, this tax anomaly can lead you to sell the stock earlier.
No Withholding: Prepare To Pay Taxes
If you sold stock from a tax-qualified ESPP this year, or plan to near the end of the year, no tax withholding is involved (as noted above, withholding does apply to nonqualified ESPPs). While you do not have any Social Security or Medicare tax, you will trigger ordinary income tax at the time of sale. As explained earlier, this tax will occur whether or not you met the holding period for long-term capital gains.
Alert: Be sure you put aside the money you will need to pay the tax you will owe with your 2015 tax return when you file it in 2016. Should the amount be large, you will want to check whether you should pay estimated taxes.
If you sold ESPP stock this year, or plan to near the end of the year, no tax withholding is involved. Be sure you put aside the money you will need to pay the tax you will owe with your tax return.
If you have shares from an ESPP that is not tax-qualified, they are treated like nonqualified stock options. Therefore, you do not need to think about estimated taxes (unless you are in a higher tax bracket), as tax withholding on the discount spread was done at the time of purchase. This withholding is done at the supplemental wage rate of 25% for federal tax, alongside whatever rate applies for your state (if it has an income tax), plus Social Security and Medicare.
Charitable Donations Of Appreciated Stock
If, as a result of an ESPP purchase from past years, you have securities with a low tax basis, consider making any charitable donations with those securities rather than with cash. When you donate appreciated stock that you have held for over one year from the purchase, you get a charitable deduction for the full market value at the time of your donation. By gifting the securities directly to a charity or through a foundation or donor-advised fund, you also avoid the capital gains tax that would otherwise be due on the sale of the securities.
Alert: Be careful not to donate stock that you received on the purchase of ESPP shares until the disqualifying disposition period has passed (at least one year after purchase and two years from grant).
Be sure the stock transfer is completed by December 31 to make it count for the current tax year. For electronic transfers from your brokerage account, the donation is recorded on the day it is received by the charity/foundation (not when you approve the transfer). With increased year-end activity at brokerage firms, you should plan your year-end stock gifts as early as possible and have ongoing communications with your broker to ensure that the transfer takes place.
Gifting Company Stock To Children, Elderly Parents, Or Other Relatives
If your company's stock price is still far from its historic high, now may be a good time to consider gifting stock or even setting up a grantor-retained annuity trust, depending on your other income and stock holdings. Be aware that there is an annual limit on the value of stock gifts that prevents any reduction in your estate tax exemption and lifetime exemption from gift tax, and also that there is uncertainty about the future gift and estate tax rates. The amount of the gift tax exemption for 2015 is $14,000 per recipient, or $28,000 per recipient if you split the gift with a spouse.
The long-term capital gains rate for people in the 10% and 15% income tax brackets is 0%.
For people with low incomes in the 10% and 15% tax brackets (e.g. elderly parents in retirement), the long-term capital gains rate is 0%, so they can sell gifted stock without paying tax on the gain.
Alert: Gifting ESPP stock does not let you escape the ordinary income tax that is based on the discount spread at the start of the offering.
However, the capital gains rate of 0% on low incomes is usually not available to help students. If you plan to gift stock to your children for their educational expenses, be aware that the "kiddie tax" now taxes children's gains at their parents' rate until the children turn 19, and will apply up to age 24 for full-time students who are funding less than half of their own support.
Start Early, Think Ahead
Remember that investment objectives, not tax considerations, should drive your decisions. However, the planning ideas above, if they are relevant to your situation, can help you avoid paying more tax than you need to. Remember also that the time for tax planning is before the year ends, not during tax-return season itself.
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Morgan Stanley Smith Barney LLC ("Morgan Stanley"), its affiliates and Morgan Stanley Financial Advisors do not provide tax or legal advice. Clients should consult their personal tax advisor for tax related matters and their attorney for legal matters.
Diversification does not assure a profit or protect against loss in a declining financial market.
Companies paying dividends can reduce or cut payouts at any time.