When you purchase stock under an employee stock purchase plan (ESPP), the income isn’t taxable at the time of purchase. You’ll recognize the income and pay tax on it when you sell the stock.

When you sell the stock, the income can be either ordinary or capital gain. The sale will qualify for capital gain treatment as long as the stock is held for both of these time periods:

• At least 2 years after the option is granted
• At least 1 year after you buy the stock

Also, the individual must remain a company employee until at least 3 months before exercising the option.

When you sell the stock, and meet the above requirements, you recognize 2 types of taxable income:

• If you meet the holding-period requirements, the amount of ordinary income recognized on the sale depends on the option price.
  • The option price might be less than the fair market value of the stock on the date you received it. If so, you have ordinary income to the extent fair market value is more than the option price.
    • Report this income as wages on Form 1040, line 7. The stock’s basis includes the ordinary income recognized in the sale year.
  • The option price might not be less than the fair market value of the stock on the date you received it. If so, treat the income as long-term capital gain.
    • Report the capital gain on Schedule D. The stock basis is the option price. Capital gain, for any income more than the ordinary income, is determined above.
• If you don’t meet the holding period requirement, it’s a disqualifying disposition and you recognize ordinary income. To figure the ordinary income amount:

1. Determine the fair market value of the stock on the date you received it (exercise date).
2. Subtract the amount paid for the stock (option price).

The ordinary income might be more than the gain on the sale. The stock’s basis is the total of both:

• Ordinary income amount
• Stock’s option price

Report the amount of ordinary gain as wages on Form 1040, line 7.

Losses on the sale of ESPP stock are capital losses.