The Canadian Capitalist posted today about how Employee Stock Purchase Plans are taxes. Particularly, he points out that any discount you receive on the stock purchased is taxed as employment income (i.e., at 100%), whereas any gain (between the market price and your selling price) is taxed at the capital gains rate of 50%.
I thought that I would add his information by providing a couple examples. I once worked at Nortel and was given the great privilege of purchasing stock at a 15% discount. A discount on a stock that’s rising fast, “what a bargain” I thought, and jumped right in. At the time I did not really understand what I was doing, I simply saw the ever increasing prices and a supposed discount.
The market value of the stock near its peak was $120/share. Let’s say that I bought 40 shares of NT at a 15% discount, for which I paid $4080. (Note that this is hypothetical since I don’t remember the specifics, but the idea is the same).
$120/share x (1 – 0.15) = $102/share
$102/share x 40 shares = $4080
But the market value of the purchase was actually $4800. So, my taxable income for this purchase was $720 regardless what happened to the price of the stock. The tax bill was $360 (%720 at the 50% marginal tax bracket). After the stock plummeted and became worthless, I lost most of my initial investment of $4080 and I still owed $360 in tax!
Many JDS Uniphase employees were far worse off. They received huge discounts on their ESPP’s for stock that eventually lost most of its value. The result, in some cases, were six digit tax bill’s. (Although they all got off the hook due to a parliamentary an act of kindness.
I admit that I do not like ESPPs simply because I got burned. However, if you have a plan, an ESPP can still be beneficial. A good plan would be to sell the stock as soon as possible. Assume that I could have sold the same day, for the same price, that I bought the stock then I would have made $720 minus my tax bill. I’d net $360 on a $4080 initial investment, an 8.8% ROI!
1 response so far ↓
1 Canadian Capitalist // Sep 27, 2007 at 17:39
Thanks for the link. I always sell ESPP shares the very next day. The way I see it, a 15% discount works out to at least a 17% gain over 6 months. Even if I pay 50% tax, that’s a 8.5% after tax return. Not too many free lunches like that around!
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