How am I affected by the tax change to my ESPP?

November 2008: A few months back a respected colleague of mine asked me to comment on the pending, now implemented, tax change to our Employee Stock Purchase Plan (ESPP). Consider this my response.

First let's understand the change. My company offers, as a benefit they proclaim, company stock at a 15% discount of the stock price. For example, if the stock is trading at $25 on the market, we can buy it for $21.25 (i.e. .85 * 25). You have to pre-allocate dollars from your paycheck and can only purchase at the market close of each quarter.

When you sell the stock you must pay income on the 15% the company gave you as a benefit. Before the tax change; if the stock sold for $25, I bought at $21.25 via the ESPP, then turned around and sold it for $25, I'd have to pay income taxes on $3.75.

Moreover, if the stock sold for $25, I bought at $21.25 via the ESPP, then kept it, I wouldn't have to pay any income on the potential gain until I sold it. As a side note, this is what I've done and thus never claimed any income. I'm actually far in the hole and would be able to claim a loss of income if I sold the &%$#@ shares today, Yes, I'm a bit miffed over the ordeal.

This approach is simple and straightforward. However, we all know that it's in our best interest to make taxes complicated and thus, the company ESPP has changed its policy on when income is realized.

After the tax change, income is realized whether you sell or keep the stock. Using the $25 example again; if the stock sold for $25, I bought at $21.25 via the ESPP, then turned around and sold it for $25 OR kept it, I pay income tax on $3.75.

My thoughts on this are twofold. First of all, it complicates your tax situation. You could buy at $21.25, pay income on $3.75 in year 1, then sell for $20 in year 2 and deduct $3.75 in income losses and $1.25 in capital gain losses (if the government differentiates the two) from year 2's taxes. I hope my broker keeps track of this for me, as I won't be smart enough to.

My second though is, you're losing the time value of money. You're paying taxes on $3.75 today, however $3.75 in year one is only worth $3.68 in year 2 (assuming 2% inflation). That sucks.

Overall, the change complicates your taxes and screws you on the time value of money. One should only expect that from big companies and government.