What you do with those shares will affect how they are to be reported. For instance, if you give your shares as a gift to someone or if you sell them, you will have to report that manipulation. If you should die while you are holding said shares, they may in fact appear on the final tax return.

Dispositions that Don’t Qualify

Any gift or sale of the disposition is considered disqualifying. The only way out of this is if it has been over a year since the shares have been purchased and it longer than two years since the offering period for said stock was in effect. Most ESPP plans have a period of offering of a year or less and even if you hold onto your shares for a year and a few days this still won’t be long enough to circumvent a disqualifying disposition.

As an example, let’s say that the company you work for has a six month ESPP period of offering. You buy you shares and fourteen months later you want to sell them off. This means that it is still a disqualifying disposition even though the shares were held for more than a year. You didn’t hold on to said shares for the two year grace period from when the stocks were offered. In order to steer clear of a disqualifying disposition you would be required to hang onto your shares for at least twenty months or more.

The Difference in Taxes

Even if you have avoided the disqualifying disposition by holding on to your shares for the required time period it may not mean you will not have to report compensation if you decide to sell your shares. This is the major difference between stock options you receive as an incentive and the ESPP plan. Just because you hang on to your shares for a longer period of time doesn’t always mean that the compensation income is eliminated.

The rules can seem a bit hazy when you get down to brass tacks so it is always recommended that before you sell or give away your shares that you speak to a financial expert that can guide you to the right decision. Those with sizeable compensations need to investigate further how they should manipulate their ESPP plan, especially in cases where the price of the stock has declined sharply.

You can do some research on the internet that will allow you to figure out the calculations on your tax responsibility for your particular situation as it relates to ESPP plans. If you feel confident enough that you have the knowledge to make the right decision for your maximum tax benefit, then go right ahead and do so. Those that feel that wading into the waters of financial matters can quickly pull them under should indeed contact a financial specialist so that they make the best decision regarding their tax situation.

The company I work for and invest a small amount in through the Employee Stock Purchase Plan has recently announced that they would be executing a 2-for-1 stock split. A stock split is simply the dividing of a company’s existing stock into multiple shares. A stock split is usually a good indicator that a company’s share price is doing well. However, a stock split doesn’t give you any more value, just twice as many shares.

For example, in a 2-for-1 split, each stockholder receives an additional share for each share he or she holds. The price of the shares are adjusted such that the before and after market capitalization of the company remains the same and dilution does not occur.

There is also a reverse stock split, which is just the same but in reverse: a reduction in number of shares and an accompanying increase in the share price.

Theoretically a stock split is a non-event. The fraction of the company that each share represents is reduced, but each stockholder is given enough shares so that his or her total fraction of the company owned remains the same.

Why then do companies perform stock splits?

The first reason is psychology. A stock split generally occurs in the face of new highs for the stock. As the price of a stock gets higher and higher, some investors may feel the price is too high for them to buy. Splitting the stock brings the share price down to a more attractive level. The effect here is purely psychological.

The actual value of the stock doesn’t change one bit, but the lower stock price may affect the way the stock is perceived and therefore entice new investors. In practice, an ordinary split often drives the new price per share up, as more of the public is attracted by the lower price. Splitting the stock also gives existing shareholders the feeling that they suddenly have more shares than they did before, and of course, if the prices rises, they have more stock to trade.

Another reason, and arguably a more logical one, for splitting a stock is to increase a stock’s liquidity, which increases with the stock’s number of outstanding shares. You see, when stocks get into the hundreds of dollars per share, very large bid/ask spreads can result. A perfect example is Warren Buffett’s Berkshire Hathaway, which has never had a stock split. At times, Berkshire stock has traded at nearly $100,000 and its bid/ask spread can often be over $1,000. By splitting shares a lower bid/ask spread is often achieved, thereby increasing liquidity, and making it easier to trade. This is always good.

After a split, shareholders will need to recalculate their cost basis for the newly split shares. Recalculating the cost basis is usually trivial. The shareholder’s cost has not changed at all; it’s the same amount of money paid for the original block of shares, including commissions. The new cost per share is simply the total cost divided by the new share count.

The most important thing to know about stock splits is that there is no effect on the worth (as measured by market capitalization) of the company. A stock split should not be the deciding factor that entices you into buying a stock. While there are some psychological reasons why companies will split their stock, the split doesn’t change any of the business fundamentals. In the end, whether you have two $50 bills or one $100 bill, you have the same amount in the bank.

In many plans, the price that you pay for the stock is the stock price at the time you started contributing to the fund, or the stock price at the time you purchased the shares (whichever is lower) with a discount of up to 15 percent. Either way, you get to buy the stock at a price that’s lower than the market price. Your discounted price is known as the offer or grant price, because your employer has offered it to you, or granted it to you.

A common ESPP would work the following way:
For six months you contribute certain percentage of your salary and compensation (up to a maximum). At the end of the six months that money is used to purchase company stock. The price at which you buy is usually discounted at 85% of the LESSER between the price at the beginning of the period and the one at the end.

You can sell it the next day after the ESPP period concludes, and you will most probably get around 100% of the value of the stock at the end of the period. You will incur a gain for doing nothing more than electing an automatic contribution to the plan. Free Money.

Chances are you will earn at least 17.6% in 6 months (17.6% = 15/85, and 6 months is a common ESPP period). That is the equivalent of an anualized 35.2%. Not too many investment opportunities give you that kind of return. There is no bank account that offers it. And most stocks can’t support that kind of growth. It is one of the best investments you can get, and many people don’t make use of it.

Let me illustrate the example better:

Situation 1: (great company)
Beginning of period price: $10.00
End of period price: $12.00 (20% gain)
Day after ESPP period price: $12.00
Purchase price: $ 8.50
Your Gain: $ 3.50 (or 41.2%)

Situation 2: (bad company)
Beginning of period price: $20.00
End of period price: $10.00 (50% drop)
Day after ESPP period price: $10.00
Purchase price: $ 8.50
Your Gain: $ 1.50 (or 17.6%)

Situation 3: (worse company)
Beginning of period price: $20.00
End of period price: $10.00 (50% drop)
Day after ESPP period price: $ 9.50 (Another 5% drop)
Purchase price: $ 8.50
Your Gain: $ 1.00 (or 11.8%)

But What About Taxes?

The company keeps the stock in your name until you decide to sell it. At that point you have to begin thinking about taxes.

When you sell the stock, the discount that you received when you bought the stock is generally considered additional compensation to you, so you have to pay taxes on that as regular income.

And, depending on when you were granted the right to purchase the stock (the grant date), and how long you have held the stock, any profit that you make, over and above the compensation, may be considered a long-term capital gain, which can be taxed at lower rates than the compensation.

How Much of the Sales Price is Compensation?

That depends on whether your sale of the stock is a “qualifying disposition” or a “disqualifying disposition”. Selling the stock is thought of as disposing of it, but the question is, what makes the sale qualify as a capital gain, at least in part?

* Qualifying Disposition: You sold the stock at least two years after the offering (grant) date and at least one year after the exercise (purchase) date. If so, a portion of the gain is considered ordinary income and will need to be reported as earned income on your Form 1040, as “compensation”. Any additional gain is considered capital gain and should be reported on Schedule D, Capital Gains and Losses. (The capital gain rate is usually less than the rate you pay on ordinary income.)

* Disqualifying Disposition: You sold the stock within two years or less after the offering (grant) date or within one year or less from the exercise (purchase) date. In this case, your employer will report the bargain element as compensation on your Form W-2, so you will have to pay taxes on that as ordinary income. The bargain element is the market price at the exercise date minus the actual price you paid for the stock, multiplied by the number of shares. Any additional gain is considered capital gain and should be reported on Schedule D.

Words of Caution:

It is never a good idea to have any one investment (stock or mutual fund) make up more than 10% – 15% of your portfolio, even your own company’s stock. Just look at Enron, or more recently Marsh & McLennan for examples of what can go wrong. When those companies ran into trouble many employees lost their jobs and their retirement savings which were primarily invested in company stock.

Selling the stock as soon as you can reduces your risk and prevent your from getting an unbalanced portfolio, but some companies require a holding period before they allow you to sell, so make sure your understand the rules of your plan.

Conclusion:

ESPPs offer free money and it’s probably foolish not to take advantage of them. The only real question is should you sell the shares immediately? You may want to ask yourself the following questions: if I had an extra money, and I didn’t worked for this company, would I buy the stock? If I keep the shares, would my stock portfolio be balanced? If the answer is yes to both, then by all means keep the stock, if not, you may want to sell immediately.