ESPP Qualifying Distribution Ordinary Income calculation

[Anonymous]

I sold ESPP stock as a Qualifying Distribution under a qualified plan with a lookback provision and 15% discount. The ordinary income amount was reported on my W-2, but is different than what TurboTax calculates.

From what I always understood, Ordinary Income for a Qualifying Distribution is calculated as (a) the FMV on the grant date x discount x number of shares (let's just assume that the sale price is much higher than the purchase price, so calculation (a) is lower). That seems to be how TurboTax is calculating it.

However, the amount on my W-2 appears to be calculated as (b) [the FMV on the grant date - Purchase price] x number of shares. With the lookback provision, as long as the FMV increases from the grant date to the exercise date, calculations (a) and (b) result in the same amount. However, in my case, the FMV decreased and the purchase price was based on the FMV on the exercise date.

For example:

FMV on grant date: $100

FMV on exercise date: $90

Discount: 15%

Purchase price: $76.50 ($90 less 15%)

(a): Ordinary Income = $15/share

(b): Ordinary Income = $23.50/share

I assumed that the amount shown on my W-2 was incorrect, but when I check the IRS guidelines for this calculation, I am not sure. From irs.gov: "You report as ordinary income (wages) on line 1 of Form 1040, U.S. Individual Income Tax Return or Form 1040-SR, U.S. Tax Return for Seniors the lesser of (1) the amount by which the stock's FMV on the date of grant exceeds the option price or (2) the amount by which the stock's FMV on the date of sale or other disposition exceeds the purchase price."

Option (1) in that statement seems to match the calculation (b). Is it possible that TurboTax is calculating ordinary income incorrectly?

[GeorgeM777]

Not sure whether the ordinary income amount is being calculated correctly.   According to ESPP tax rules, you may be subject to ordinary income tax and/or long-term capital gains tax for a qualifying disposition. The rules say that you will pay ordinary income tax on the lesser of:

1. The discount offered based on the offering date price, or
2. The gain between the actual purchase price and the final sale price.

What was the sales price for the ESPP shares you sold?  Because this was a qualifying sale, your W-2 appears to be reflecting the first option mentioned above, that is the discount amount which would be the lesser of the two options.  

@Anonymous

[Anonymous]

Hi @GeorgeM777 

In my example, let's just assume the sales price is $150, in which case the first option will be lower and will be used to calculate the amount of ordinary income.

Assuming then that option 1 is used, what you posted is different than what I see written on the irs.gov  webpage (for some reason the hyperlink gets messed up when i post...), and this is the crux of my question:

• You: "The discount offered based on the offering date price" - I interpret this to be the FMV on the offering date times the discount, which is what I wrote as calculation (a)
• irs: "the amount by which the stock's FMV on the date of grant exceeds the option price" - I interpret this to be what I wrote as calculation (b). If the FMV on the option date is the same as the offering date FMV, the result of this calculation is the same as what you said. However, if the FMV on the option date is lower than the offering date price, it's not the same.

So what I'm trying to find out is, which one is correct?

[GeorgeM777]

I found the IRS webpage you reference in the previous post.  The paragraph you cite is preceded by the following statement:

"If you meet the holding period requirement and the option price was below (but not less than 85% of) the FMV of the stock at the time the option was granted:"

It appears that you meet the holding period; however, was the option price below (but not less than 85% of) the FMV of the stock at the time the option was granted?  If yes, the ordinary income amount is calculated using one of the two methods you have cited.  

Here is the link to the IRS page referenced herein:

I purchased stock from my employer under a § 423 employee stock purchase plan and received a Form 10...

@Anonymous

[Anonymous]

Thank you @GeorgeM777 for providing the link I referred to. I'm still not sure why the link changed when I tried to post it.

The terms get a little confusing for me, so maybe it's best if I give the actual numbers:

ESPP start date FMV: $115.90

ESPP end date FMV: $110.94

Purchase price: $94.30

Sale price: $177.50

I always assumed that the "not less than 85% of" was in reference to the fact that the discount can't be higher than 15%. However, if the "option price" refers to the actual purchase price and "the time the option was granted" refers to the ESPP start date, then my option price would be less than 85% of the price at the time the option was granted. I have a feeling I have the terms wrong, but what would be the calculation if the option price is less than 85% of the FMV of the stock at the time the option was granted?

[GeorgeM777]

It appears that your discount of 15% whether based on the offering period price or the price at the end of the purchase period is consistent with a qualified plan.  You mentioned in an earlier post that your ESPP plan has a look-back feature.  A lookback provision bases the purchase price not on the stock price at the time of purchase but rather on the price either at the beginning of the offering period or at the end of the purchase period, whichever is lower. This ensures the offering-date price stays the same while the purchase-date price changes in longer offering periods with multiple purchase periods.

You are correct that if you link your actual purchase price to the higher price, either the offering period price or the price at the end of the purchase period, your discount may likely be more than 15%; however, for purposes of what your plan offers, namely the lookback provision, you get the benefit of choosing the lower price and basing the discount off of that lower price.  As long as your discount is no more than 15% based on the price at which you can purchase, your plan remains compliant with a qualified plan.

@Anonymous

[Anonymous]

I think I finally found my answer. I found the actual tax law, and there was a detail in there that was missing from the irs page linked earlier. It's the part in green, below, which makes clear that the option price is based on the FMV at the start date, even if the FMV goes down and the actual purchase price is based on the FMV at the end date.

Therefore, I believe TurboTax is doing it right (calculation (a)), the (b) calculation in my original post is not a valid calculation, and so my next step is to try to convince my company's payroll that they calculated my ordinary income incorrectly...

Thanks for your help anyway, @GeorgeM777