Tax Stock Question

[ahawkchick]

I have an amateur tax/stock question.  I have been purchasing company stock through my espp at work for a 15% discount.  I've been buying and holding for several years. 

So my question is, do I just pay capital gains tax of 15% for the difference between my cost basis and the selling price of the stock?  Does my income at the time I sell it have any bearing on the amount of tax I pay on what I sell?

I was originally thinking that I should hold on to this stock because DH and I are at higher income levels at the moment.  He’s planning to ER in 3-4 years so our income will go down.  I was thinking that if our income is lower then we don’t have to pay as much tax on the stock that we’d sell.  However, I think my logic may have been flawed and our income doesn’t matter.  What do you think? 

[Axecleaver]

You're right that you pay lower taxes on this when your income goes down. You recognize the discount you got, as regular wage income in the year you sell the stock, and the gain in price (if any) as capital gains. You have to hold the stock at least one year, and you have to be at least two years from the grant (this is usually when you enrolled in the plan). Otherwise, the whole amount is considered wage income. The last ESPP I participated in allowed people in at the start of the next quarter, so I enrolled about a month after my hire date. You should be well past the two year requirement for at least some of your stock.

The problem with ESPP's is the risk of holding a lot of your net worth in a single stock. I preferred to sell immediately and just recognize the 15% discount as regular income. If you feel like your company is stable, you might be comfortable holding on to it for a year. But you could also sell it immediately and diversify. If you have the ability to put more in your tax deferred accounts, sell it immediately and use this to fund those accounts. Then you pay income tax on the discount, but all your gains are taxed once you retire, at a lower rate.

[seattlecyclone]

Taxation of ESPPs can be a bit complicated for shares bought at a discount.

Just like with any other stock, the difference between your cost basis and your sale price is a capital gain or loss (short-term for shares you owned less than a year, long-term otherwise). If you're in the 25-35% tax bracket, you'll pay 15% of the long-term capital gains in tax. If you're in the 10-15% bracket, you pay 0% on the long-term gains.

What makes it complicated is that your cost basis is not the same as the amount you paid for the shares. There's a two-year holding period from the "option grant date." If you meet the holding period, the cost basis is generally equal to the market price of the shares on the option grant date. If you sell before the end of the holding period, the cost basis is generally equal to the market price of the shares on the purchase date. In either case, the difference between your cost basis and the amount you paid counts as compensation income in the year you sell the shares.

What's worse is that the IRS requires brokers to report the purchase price as the cost basis on 1099 forms, which is probably wrong! Your employer is required to report the compensation piece on a Form W-2. If you simply transfer the numbers on both forms to your tax return, you'll end up paying tax on the compensation piece twice: once at your regular income tax rate, once at capital gains rate. What you're supposed to do is file an adjustment to your basis for these shares when you fill out your Schedule D so that you don't get double taxed. I'm sure lots of people neglect to do this. See http://forum.mrmoneymustache.com/investor-alley/your-2014-1099-b-form-for-an-espp-sale-will-probably-be-wrong/ for more discussion on this issue.

You're right that you would likely owe less tax if you wait to sell these shares after you retire. The difference would depend on your current and expected future tax brackets. Be sure not to let the tail wag the dog here. You're taking a pretty significant risk by having this much of your net worth in one single stock. Balance this risk against the potential tax reward from holding on to the shares. I would sell all the shares over the next year or two if I were in your shoes.

[ahawkchick]

Wow, okay thank you both! 
I think we'll probably just go ahead and sell some now as we do have a bit of "tail wagging the dog" going on. We have a significant percentage of our net worth in this.  We are however already maxing out other tax deferred retirement accounts.  We both work at the same place and our company match in our 401k is also in company stock (eek I know!)  It was all fine and good and the stock has done remarkably well over the last 5 years, but has taken a dive in the last 6-9 months.