In previous articles we discussed about Stock Options in general and about NSO or Nonstatutory Stock Options (sometimes also called NQSOs), and statutory stock options such as Incentive Stock Option (ISO). Employee stock purchase plans are also considered as a form of statutory stock option.

Employee Stock Purchase Plans allow employees to buy their company stock at a discount, typically 15 percent.

ESPPs allow workers to set aside part of their paychecks (generally a maximum of 10% of their gross pay) to buy company stock for as much as a 15 percent discount. That discount typically is pegged to the price at the beginning or end of a purchase period - whichever is lower. The "lookback" period commonly runs six months but can extend as far as twenty seven months.

For example, say that a stock selling for $100 at the beginning of the purchase period increases to $150 by the end of the purchase period. Inthis case an employee in an ESPP with a 15% discount would pay $85 for a stock worth $150 - giving the employee a discount or "spread" of $65, which works out to 43.33% below the market price.

The tax consequences applicable to ESPP seem to be in a state of flux, because of certain IRS actions. However in the past the following were the accepted norm:

GRANT : There are no tax consequences to the employee or the employer upon the grant of employee stock purchase plan rights.

EXERCISE : ESPP rights are "exercised" through payroll deductions in amounts equal to the number of share rights granted times the strike price.

ESPP QUALIFYING DISPOSITION

Dispositions of stock held for the longer of one year from the date of purchase of ESPP shares or two years from the date of the beginning of the

applicable ESPP offering period are qualifying dispositions. Employee - In a qualifying disposition, the employee will recognize ordinary income equal to the lesser of the discount as of the date of grant (i.e., the difference between the fair market value of the stock at the

time the option was granted and the option price) or the total gain (sales price less purchase price). The remainder of the gain is a long-term capital gain. Employer - No reporting of income or withholding of employee income taxes is required in a qualifying disposition of ESPP stock. No tax deductions are available to the employer as a result of qualifying dispositions.

Example - ESPP Qualifying Disposition

Number of Shares: 200
Date of Grant: January 1, 1997
Option Price: $11.00 per share
FMV Date of Grant: $12.90
Date of Exercise: July 1, 1997
FMV Date of Exercise: $15.00
Date of Sale: January 2, 2000
FMV Date of Sale: $20.00

In 2000, there is a qualifying disposition. Upon sale of stock, $380 is reported as ordinary income and $1,420 as long-term capital gain.

Selling price (200 shares x $20.00) $4,000
Purchase price (200 shares x $11.00) $2,200
Gain $1,800

Amount reported as ordinary income
[200 shares x ($12.90 - $11.00)] $380 **

Amount reported as long term capital gain
[200 shares x ($20.00 - $12.90)] $1,420

* * this will not be included in the employee's  W-2

ESPP DISQUALIFYING DISPOSITION

Dispositions of stock held less than two years from the beginning of the ESPP offering period or less than one year from the date of purchase are

disqualifying dispositions. Employee - In a disqualifying disposition, the employees will recognize ordinary income equal to the difference between the fair market value of the stock on the date of purchase and the purchase price Any remaining gain or loss is a capital gain or loss. (See examples below).

Employer - Ordinary income recognized by an ESPP participant on a disqualifying disposition is reported on the employee's Form W-2 and is deductible as compensation expense by the employer. Similar to disqualifying dispositions of incentive stock options, the employer will need to track employee dispositions of stock acquired through an ESPP in order to identify deductions as a result of disqualifying dispositions.

Example - ESPP Disqualifying Disposition

Number of Shares: 200
Date of Grant: January 1, 1998
Option Price: $11.00 per share
FMV Date of Grant: $12.90
Date of Exercise: July 1, 1998
FMV Date of Exercise $15.00
Date of Sale: December 31, 1999
FMV Date of Sale: $20.00

In 1999, there is a disqualifying disposition. Upon sale of stock, $800 will be reported as ordinary income and $ 1,000 as long-term capital gain.

Selling price (200 shares x $20.00) $4,000
Purchase price (200 shares x $11.00) $ 2,200
Gain $1,800

Amount reported as ordinary income
[200 shares x ($15-00 - $11 .00)] $ 800

Amount reported as capital gain
[200 shares x ($20.00 - $15.00)] $1,000

If shares are sold for $13 per share, then there is a long term capital loss of $400 [200 shares x ($15.00 - $13.00)]

WITHHOLDING REQUIREMENTS

The withholding requirements related to ESPP stock are somewhat controversial. Many practitioners and the majority of Silicon Valley companies believe Revenue Ruling 71-52 applies to ESPP transactions in addition to ISO's. The IRS has recently stated in several private letter rulings that the ruling does not apply to ESPP transactions. Below is a summary showing the withholding and reporting positions of the IRS and the majority of Silicon Valley companies.

Companies generally have not withheld either payroll or income taxes, but the IRS contends the employer and employees both owe payroll taxes on the discount, notably FICA made up of Social Security and Medicare totaling as much as 15.3%. Companies that fail to withhold payroll and income taxes may be held liable for paying the amounts the employee owed.

As the IRS, the courts and hopefully Congress continue to consider ESPPs with respect to both income and employment tax withholding requirements, this issue should continue to be closely monitored, especially in Silicon Valley.

Disclaimer: Most of the time the general rule is stated, but there may be exceptions or certain conditions to be met before the general rule can beapplied. The information in this article SHOULD NOT be acted upon without first checking with a professional to determine its applicability to your

situation.

(C) Copyright Anil Deora 1999.

Anil Deora, B.Sc., B.L., MBA is a Management Consultant and Registered Tax
Preparer based in the Bay area. He can be reached at Tel: (408)-865-0700.

email: deora@rightskills.com.
Please see this and other articles at
www.indzine.com/adeora/taxes

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[This info to go in a table before the last 2 paras]

IRS Approach: Silicon Valley Approach:

Event Consequences Consequences

ESPP Purchase No income tax with No tax withholding or holding or reporting. reporting." Spread" is subject to FICA and FUTA tax withholding. ESPP quali No tax withholding No tax withholding or Disposition or reporting or reporting. ESPP " Spread" reported on " Spread" reported on Disqualifying Form W-2 and subject Form W-2 No Tax Disposition income tax withholding.