Understanding ESPP income tax can be a little confusing at times. The Employee Stock Purchase Plan (ESPP) provided by many publicly traded companies is a great benefit but the benefit calculation is not simple if you are not familiar with stock investing.
I have seen many make the same mistake and user the wrong purchase price to calculate their personal capital gains income tax. It usually results in overpaying so I encourage everyone with ESPP to educate themselves on the ESPP income tax details.
You essentially purchase your shares at 2 different prices:
- The actual price you pay for the stock (usually including a discount price from your employer)
- The market price of the stock on that day
It’s important that you understand both in order to do your taxes. ESPP is a benefit from your employer. Every benefit is taxed at your marginal tax rate in Canada. The capital gains on a stock is from your purchase of stock usually done with the after-tax money.
The income tax on ESPP is two-fold. You have to pay regular tax on the discounted price you get and then you pay capital gains on the profit. Let’s look at an example for each step.
- ESPP share discount
- ESPP capital gains
Related: ESPP – When Should You Sell?
ESPP Benefit Explained
The benefit you get from your employer is not the ability to purchase the stock but the ability to purchase the stock at a discount. The discount part is taxed at your marginal tax rate.
For example, company ABC trades at $20 on the day of purchase. That’s your market price of the ABC stock. If your employer has a 20% discount for you, you pay $16 for the ABC stock. You have an automatic $4 profit :) which is automatically taxed as a benefit at your marginal tax rate. Depending on the company policies, you can be charged the taxes on the $4 in your future pay period. The income taxes you pay on this benefit will be taken into account on your future employer T4 tax form. It’s important to remember that and that your purchase price from a stock investment perspective is not $16 but $20 now. See the next section
Capital Gains on ESPP Explained
Now that you have paid taxes on your employee benefit, your stock in ABC is simply a stock like any other investments. What’s important to remember is the market price you receive the shares at. That’s your price for calculating your future capital gains income taxes.
Assuming your employer does well and the company stock goes up to $25 and you sell. Your capital gains are now $5 ($25 – $20) multiplied by the number of shares you own.
IMPORTANT – Many employees make the mistake to use the price from the benefit and report a higher capital gain and therefore pay higher taxes than they should be. If you utilize a service for your taxes, make sure they have the necessary statement from your company as the purchase price at your broker could be the benefit price.
Tracking your investment becomes important for tax purposes. If you are not setup, I recommend you learn how to set up a spreadsheet to do the tracking. If you plan on holding your ESPP for years, that’s a lot of tracking that is needed and it’s on you to track, your company will only manage the benefits, any future transactions for capital gains will be on your to establish the profit.