Tax rules change for stocks bought through employer plans, experts warn

By Mark Schwanhausser
Knight Ridder News Service

Calculating the tax on a stock investment usually is simple. You subtract your cost from the sales price. If you held the stock at least a year, it's taxed as a long-term gain.

Unless, that is, you're one of the up to 15 million American workers who buy discounted company stock through an employee stock purchase plan. Then you fall into the "Twilight Zone" of taxation, where time not only is stretched, it takes two clocks to measure it. Moreover, some or all of your profit could wind up as "wages" on your 1040, not as investment gain on Schedule D.

Workers stumble into tax traps because they don't understand ESPPs are akin to incentive stock options.

"With the economic pressures people are under, they're just looking anywhere for cash," said Michael C. Gray, a CPA in San Jose, Calif., who founded the Employee Stock Option Advisors Association. "So they'll sell these ESPPs and ... end up having a significant problem."

It's not enough to hold ESPP stock one year from the day you bought it. You also must hold it two years from the date of grant, which typically is the start of a three- or six-month offering period. That means riding the stock 18 to 21 months, not 12.

Say that a stock sold for $10 at the beginning of the offering period and $11 at the end. Many companies give workers a 15 percent discount off whichever price is lower. In this case, you'd pay $8.50. Here's how the tax burden would compare, according to Kaye Thomas, author of "Consider Your Options":

If you meet both holding periods.

Your company should include the difference between what you paid ($8.50) and the price at the beginning of the offering period ($10) in your W-2 along with wages and bonuses. That's $1.50 taxed at rates up to 38.6 percent. Tip: Add the $1.50 to your basis to avoid paying the taxt again on Schedule D.

When you don't meet the holding periods.

This is known as a disqualifying disposition, and it means you'll report more W-2 income. This time the income is based on the spread between what you paid ($8.50) and the price you would have paid in the open market ($11).

Here's where these rules can bite hard: It's possible to report both income and a capital loss on the same transaction.

Karen Brosi, director of financial planning at Moorman and Co. in Palo Alto, Calif., recalls a client who watched her stock soar during the offering period, then plummet after her purchase date. A year later, she bailed out with what she thought was a meager long-term gain. When she was told she had a big income-tax bill and a hefty capital loss instead, she was in tears.

"She basically slit her own throat taxwise," Brosi said. "She owed tax on $35,000 to $40,000, and it was completely phantom income, income she would never, ever see."